RRSPs: 10 Tips to Save, Borrow, and Reduce Taxes
KEY POINTS
A Registered Retirement Savings Plan (“RRSP”) is a very complex investment vehicle with advantageous tax attributes.
The complexity is compounded by other related considerations: borrowing, investing, cash management, impact on Old Age Security and the Guaranteed Income Supplement, estate transfer issues, and more.
Our 10 tips highlight some of the key planning opportunities related to RRSPs. Your financial advisor can help ensure your RRSP is properly integrated into your strategic plan.
Account Types
All investments involve a degree of risk and require you to perform your due diligence prior to investing. The type of investment account you hold your investments in is a critical component of your due diligence process.
Investors can hold securities in three main types of accounts:
RRSP
Tax-free savings account (“TFSA”)
Non-registered account
In this post, we will focus on the unique tax, investment, and borrowing considerations related to an RRSP. Taxation can be very complex and poor planning in this regard can have a devastating impact on your portfolio.
RRSP Overview
An RRSP is a tax deferred savings vehicle that was first introduced in 1957. It allows taxpayers to contribute to a designated account subject to prescribed annual maximum contribution limits. Such contributions are tax deductible by the individual and can reduce the individual’s taxes payable based upon their marginal tax rate.
RRSP Top 10 Tips
1. Maximize Contributions
The power of compounding annual returns is enhanced when applied to tax deferred investments. Therefore, maximizing contributions to your RRSP is a key component of achieving your investment goals.
Contributions are limited to the lesser of 18% of an individual’s prior year earned income as reported on their tax return and the prescribed contribution limit. The prescribed contribution limit changes every year and is $30,780 for 2023.
The unused contribution room is carried forward to subsequent years on a cumulative basis.
Your contribution room is permanently reduced upon contributing to your RRSP. Therefore, unlike a TFSA, a subsequent withdrawal from your RRSP will not increase your contribution room.
2. Do Not Over Contribute
The Canada Revenue Agency (“CRA”) will apply a 1% per month penalty on over contributions exceeding $2,000. The penalty can be avoided if the over contributed funds are withdrawn before the end of the month in which the over contribution took place.
You should check your cumulative contribution room on your annual Notice of Assessment provided by CRA, prior to investing in your RRSP.
3. Timing of Contributions Claimed and Withdrawals Received
You must report your RRSP contributions to CRA on Schedule 7 of your tax return in the year such contributions are made. However, you can choose to deduct the contributions from your taxable income of a different taxation year.
For example, you may expect your income next year to be substantially higher than the income earned this year when you made the contribution to your RRSP. Therefore, you may choose to claim your contributions against next year’s income as such income may attract a higher marginal tax rate and larger RRSP related tax benefit.
Similarly, you should strategically plan your RRSP withdrawals. If your non-RRSP income will vary year-to-year you can adjust the annual withdrawals from your RRSP to achieve the lowest average tax rate possible.
4. Reduce Taxes Withheld from Your Pay Stub
Do you make regular RRSP contributions throughout the year without having your employer reduce the taxes withheld from your paycheque? If so,
STOP giving the government an interest free loan linked to your RRSP contributions
These amounts can have a substantial impact on your retirement savings.
We modeled a single taxpayer in Ontario earning $100,000 of taxable income for 40 years. An annual $16,000 RRSP contribution would generate approximately $5,000 refund which is invested in a TFSA earning a 6% annual rate of return.
A future TFSA balance of approximately $778,000 was generated when investing the $5,000 annual lump-sum tax refund. In comparison, a future TFSA balance of approximately $834,000 was generated when having the employer reduce the taxes withheld throughout the year by $5,000 and investing such savings monthly in a TFSA. The net result is an approximate increase of $56,000 in retirement savings.
Your experience will vary depending on your taxable income, marital status, and more.
How do you reduce your taxes withheld?
Reduce the tax deducted by your employer by filing form T1213 Request to Reduce Tax Deductions at Source with the Canada Revenue Agency (“CRA”). This form needs to be submitted to CRA annually.
5. Income Splitting – Spousal RRSP
The ability to split / allocate taxable income between spouses can be a very powerful tax planning tool.
A spousal RRSP allows you to effectively shift current income from the spouse with the higher marginal tax rate to a future period when it will be taxed in the hands of the spouse with a lower marginal tax rate.
How does this work?
Let’s assume the spouses’ top marginal tax rates are 50% and 20% and the contribution is $1,000. For simplicity, we will assume these tax rates remain unchanged over time and the RRSP savings are invested in cash earning no rate of return.
The higher income spouse makes a $1,000 contribution today to a spousal RRSP and reduces their taxes payable by $500 (1,000 * 50%).
The assets in the spousal RRSP become legal property of the receiving spouse. At a future date, the receiving spouse will withdraw the funds from the spousal RRSP and remit taxes of $200 (1,000 * 20%).
The 30% tax savings can have a substantial impact on your future after-tax earnings.
Such tax savings rates are for illustrative purposes only. Your experience may vary substantially based on the incomes of you and your spouse in the years of contribution and redemption, changes in tax rates, and more.
Be aware that if contributions to a spousal RRSP are withdrawn within 3 years of the contribution date, such amounts withdrawn will be taxed in the hands of the contributing spouse. Therefore, this tax planning tool should only be utilized with a minimum time horizon of 3 years.
6. Allocation Between Accounts: RRSP / TFSA / Non-Registered
This post is focused on investing through an RRSP which is a tax-deferred account. However, many readers will also invest through Registered Retirement Income Funds (“RRIF”), TFSA, and taxable non-registered accounts.
Your allocation of securities amongst these types of accounts can have a significant impact on your after-tax savings potential.
Typically, it is tax efficient to allocate securities that generate income taxed at the highest rate to a registered account (RRSP, RRIF, TFSA) and those securities that generate income taxed at a lower rate of tax to non-registered accounts. The following are the main types of taxable income related to investments and such is written from a Canadian investor’s perspective.
Interest
Interest income is fully taxable. It can be generated from investments including, but not limited to, cash, money markets, GICs, T-bills, and mutual fund trusts.
Dividends
Dividends may experience preferential tax treatment. They are generated from investments in stocks that declare and pay dividends. Not all companies pay dividends.
The tax treatment of dividends can vary for several reasons. A primary determining factor is the domicile of the issuing corporation: Canada, United States, and other.
The effective tax rate paid may be reduced due to the dividend tax credit or the recovery of withholding taxes through the foreign tax credit. Such are dependent upon the domicile of the issuing corporation and which type of account the securities are held within.
Capital Gains
Capital gains income is 50% taxable. They are generated when you sell an investment at a price that is greater than its adjusted cost base. Such may be generated from the sale of bonds, stocks, mutual funds, exchange traded funds, options, investment properties, and more.
A stock may generate dividend income while you hold it and a capital gain when you sell it. The dividends and capital gains will be taxed differently.
Similarly, a bond may generate interest income while you hold it and a capital gain when you sell it. The interest and capital gains will be taxed differently.
We recommend you obtain advice from your financial advisor when allocating such securities between accounts. Your specific tax situation (e.g., province you reside in, income level, marital status, dependents, etc.) and your expectations of income generation between dividends, interest, and capital gains will necessitate a tailored strategy unique to you.
7. Planning for Government Programs During Retirement
RRSP income may impact your benefit payments, if any, related to the Old Age Security (“OAS”) and the Guaranteed Income Supplement (“GIS”) programs offered by the Canadian government.
We will highlight the impact on OAS in this post.
Most people living in Canada over the age of 65 will receive Old Age Security (“OAS”) benefits. The maximum annual payout in 2023 is $8,292 ($691.00*12) for ages 65-74 and $9,121 ($760.10*12) for ages 75 and over. The annual benefit amounts are indexed to inflation with only positive changes reflected in the benefit adjustment.
You will be required to repay a portion of your OAS benefit equal to 15% of the amount by which your income exceeds a prescribed threshold, if any. Such threshold is $86,912 for 2023 and it changes annually in relation to changes in the OAS annual benefit. Such repayment is often referred to as a clawback.
Most Canadians will not earn sufficient income after age 65 to trigger the clawback and those that do may not consider it financially significant. However, a potential annual repayment of $9,121 is worth considering some planning options.
You may be able to manage your withdrawals from your registered and non-registered accounts to optimize the number of years you qualify for OAS without incurring a clawback penalty. Such may include withdrawals prior to age 65.
Spouses are also able to split pension income (RRSP income is not considered pension income, whereas income from a RRIF is considered pension income). Therefore, you may be able to split your non-RRSP pension income to minimize any potential OAS clawback.
8. Borrow From Your RRSP
The Canadian government has created the following two programs linked to the RRSP aimed at helping taxpayers purchase their first home and obtain a post-secondary education.
The Home Buyer’s Plan (“HBP”) allows eligible first-time home buyers to borrow up to $35,000 from their respective RRSPs to purchase or build a qualifying home for themselves or for a related person with a disability. You and your spouse or common-law partner can both withdraw $35,000 each from your respective RRSPs, if you both qualify as first-time home buyers. Your RRSP issuer will not withhold taxes on the amount withdrawn with respect to the HBP.
The intention must be to occupy the house within one year after buying it or building it and the loan must be repaid within 15 years.
You may be able to participate in the HBP more than once if your repayable HBP balance on January 1 of the year of withdrawal is zero. There are several other specific conditions that must be met. A key one to consider is that you must not have lived in a home that you or spouse or common-law partner owned during the previous 4 years. Therefore, you must have sold your prior home and lived in a rental for such 4-year period.
The Lifelong Learning Plan (“LLP”) allows you to withdraw up to $10,000 per calendar year from your RRSP to fund full-time training or education for you or your spouse or common-law partner. Any amount withdrawn over $10,000 in a given calendar year will be included in your taxable income. The maximum cumulative withdrawal from your RRSP is $20,000.
The amount you withdraw is not limited to the amount of your tuition or other education expenses.
You can make withdrawals every year, provided you continue to meet the LLP requirements, until January of the fourth calendar year after the year you made your first LLP withdrawal.
You cannot make withdrawals to support the educational pursuits of your children or your spouse’s or common-law partner’s children.
9. Employer Sponsored Group RRSP
You should take advantage of any contribution matching offered by your employer. Once invested, such group RRSP plans may provide access to a financial advisor, diverse investment options, and potentially lower fees. You can invest in a variety of assets including cash, fixed income, equities, exchange traded funds, mutual funds, income trusts, options, and more.
10. Taxation Upon Death
Upon death of the RRSP account holder the assets are transferred directly to the beneficiary named on the account as the RRSP does not form part of the estate for probate purposes. The RRSP can continue and maintain its tax-deferred status if the beneficiary is a spouse or common-law partner. Such tax deferred transfer can also be made to dependent children and grandchildren under 18 years of age, or a financially dependent mentally or physically infirm child or grandchildren at any age.
The full amount of your RRSP will be added to your estate’s taxable income in the year of death unless you have named your spouse, common-law partner, or specific dependents as a beneficiary of the RRSP.
Such income may be taxed at the highest possible marginal tax rate
Consider reducing your annual RRSP contributions, or even implementing a systematic withdrawal plan, if you have not named any beneficiaries that will qualify for a tax deferred transfer upon death. Such may produce a lower tax impact than if your estate were to be taxed at the highest rate upon your death. You will have to perform a financial sensitivity analysis to see if this option is worth taking the risk.
Another option is to consider making a charitable donation in your will. The tax benefit resulting from a gift to a registered charity can be used to offset the taxes related to your RRSP and overall estate.
BOTTOM LINE
An RRSP can be a very powerful tool when saving for retirement. It often requires the integrated planning of taxation, investment management, borrowing/leverage, cash management, government income supplement programs, estate transfer issues, and more.
We cannot emphasize enough the importance of working with a trusted advisor to ensure you are on track to achieving your goals while taking an appropriate amount of risk.
Your research may be enriched by referencing the following external links:
RRSP - CRA - FORM T1213 Request to Reduce Tax Deductions at Source
RRSP - CRA - Home Buyers' Plan Overview
RRSP - CRA - Home Buyers' Plan Request to Withdraw Funds from an RRSP
RRSP - CRA - Lifelong Learning Plan Overview
RRSP - CRA Lifelong Learning Plan - Request to Withdraw Funds from an RRSP
