The RRSP Decision
For most taxpayers, the registered retirement
savings plan (RRSP) is an effective vehicle for immediate tax savings. Not only does an
RRSP serve as a tax shelter, by allowing investment income to grow tax-free, it also
allows you to deduct your contributions from taxes payable.
RRSPs are an attractive investment.
But like all investments, there are pros and cons
to consider in view of your specific circumstances and financial goals.
The Pros…
An RRSP is a formal arrangement that allows you to
invest in "qualified investments" that are designated as "registered"
for retirement purposes. Some of the advantages of this investment include:
• Your
RRSP contributions reduce your taxable income and, therefore, reduce the income taxes
payable in the year the deduction is claimed. This allows a greater amount to be invested
than if unregistered investments are made. You can continue to contribute until December
31 of the year in which you turn 69, at which time the plan "matures". If you
cannot contribute because of your age, you can still contribute to your spouse's or
common-law partner's RRSP until the end of the year in which he or she turns 69.
• Your
investment in your RRSP can be as little or as much (within the contribution limits set by
the CRA) as you can afford to save. Generally, the amount you can contribute to your own
RRSP or to your spouse's or common-law partner's RRSP for a given tax year is determined
by your RRSP deduction limit. Called your "contribution room", this amount is
indicated on your latest Notice of Assessment or Notice of Reassessment.
• A
variety of investments can be held in an RRSP, including mutual funds, GICs, stocks, bonds
and cash.
• Certain
types of payments (e.g., transfers of funds between registered plans) can be transferred
directly to your RRSP on a tax-free basis rather than receiving the amounts currently and
being subject to tax on it in the year received. The RRSP deduction limit is not reduced
by these transferred amounts.
• If
you are unable to contribute the maximum amount allowed in any year, you may carry forward
the unused portion and contribute in a future year up to the amount of your contribution
room for that year. Deferring contributions until a year in which you are in a higher tax
bracket will produce better tax savings and may result in higher returns.
• Any
interest, dividends or capital gains that are earned within your RRSP plan are not taxed
until they are withdrawn from the plan. This can result in substantial savings in taxes if
your income (and marginal tax rate) is lower at the time you make withdrawals for your
retirement.
• RRSP
funds can be a source of "emergency" funds if the need arises in a year in which
your income is particularly low but the withdrawal must be added to your income and will
be fully taxable in that year. Note that it is not possible to repay these withdrawals
unless you use your current RRSP deduction limit.
• In
certain circumstances, you can borrow from your RRSP to purchase a house or for
educational purposes using the Home Buyers' Plan or the Lifelong Learning Plan without
paying tax on the amounts on a current basis.
• You
can arrange to have RRSP contributions deducted on a regular basis from your pay cheque or
bank account. Having a "forced savings" program will help ensure that you
contribute the maximum amount in a given year.
• The
growth in tax-deferred RRSP investments can create a substantial retirement fund. For
example, contributing $500 per month from the age of 25 to 65 with only a 5 % return on
your investments would accumulate $763,010. Of that amount, $523,010 would be investment
earnings.
• In
the event of death, RRSPs can be transferred to a spouse's or common-law partner's RRSP on
a tax-free basis. That is, the balance within the RRSP is not deemed to be taxable income
to the deceased taxpayer. Rather, your spouse or common-law partner will pay tax on any
RRSP withdrawals or tax on the full amount of the remaining RRSP at the time of his/her
death.
• The
2005 Federal Budget eliminated the previously set foreign content limit of 30% for RRSPs.
This means 100% of the book value (original cost) of your RRSP can be foreign content.
While this allows you more international diversification opportunities, it is important to
remember that the foreign content is only one portion of a well-diversified portfolio.
The Cons…
An RRSP is a way to postpone the payment of income
taxes, not eliminate them.
Consider also:
• You
cannot claim capital losses realized on the sale of investments within your RRSP against
gains on other investments you have outside of your RRSP. The only relief for these losses
is that ultimately there is less in your RRSP resulting in lower withdrawals and,
therefore, less tax in your retirement years.
• The
special rules that exist for investment income earned outside the RRSP are not available
for investments within the RRSP. These benefits include the one-half inclusion of capital
gains in income, the reduced tax on dividends from Canadian corporations and the $500,000
lifetime capital gains exemption for investments in qualifying small business
corporations. For this reason, in determining your overall asset mix, it is usually best
to hold your interest-bearing investments in your RRSP and hold growth and/or dividend
paying securities outside of your RRSP.
• There
is no relief for foreign taxes withheld from foreign income earned within the RRSP. This
loss of a foreign tax credit can reduce your investment returns.
• When
the RRSP matures, the funds must be withdrawn in the current year, transferred to a RIFF
or used to purchase an annuity. No tax is withheld on amounts transferred to a RIFF or
used to purchase an annuity. However, if funds are withdrawn from your RRSP, tax will be
withheld and you must include the amount withdrawn in your income for that year and likely
pay additional income taxes.
• If
your income is higher in your retirement years than at the time the RRSP deductions were
claimed, you could end up paying more tax in retirement than you saved in the earlier
years. The benefit of tax-free growth over many years often offsets this cost. For this
reason, it may not be advisable to make RRSP contributions when your income is low,
particularly when age 69 is approaching.
• Amounts
that you contribute in a year in excess of your RRSP deduction limit may be considered
excess contributions. A tax of 1% per month applies on the portion of your RRSP
contribution that exceeds your RRSP deduction limit and the over-contribution limit of
$2,000.
• If
you have sufficient retirement income from other sources, such as the Canada Pension Plan,
a registered pension plan, a deferred profit-sharing plan or real estate, you may not have
to withdraw funds from your RRSP early on in your retirement. Although this may allow you
to stay in a lower income tax bracket, the downside is that when the RRSP plan matures,
the mandatory RIFF, annuity or withdrawal may place you in a higher income tax bracket.
This increase in retirement income may cause some or all of your Old Age Security to be
eliminated.
• Interest
on funds borrowed for an investment in an RRSP is not tax deductible whereas interest on
funds borrowed for an investment outside of an RRSP is deductible.
• RRSPs
cannot be used as security by lenders. If you do use it as security, the value of the RRSP
is included in your income.
• You
cannot deduct the costs of investment advice or brokerage fees incurred for your RRSP
investments.
Considering the pros and cons of RRSPs is the
first step in determining whether you wish to commit to RRSPs as part of your investment
strategy.
Managing Your Investments
In planning for your retirement, be sure to
investigate the pros and cons of the many RRSP-eligible and non-RRSP eligible products in
the marketplace.
Managing your investments along with minimizing
your personal income taxes are important factors in determining your future income
security.
Your chartered accountant can assess the income
tax implications of your retirement planning and advise you on ways you can make your
investment portfolio "tax-efficient". |
