7 RRSP Planning Tips
Contributing to your RRSP is one of the most beneficial and efficient ways to both save for retirement and reduce your taxes.
RRSPs offer immediate tax relief by lowering your taxable income. There are also ways to lower how much tax your employer withholds from your pay-cheques ensuring that you do not over-pay on your income tax – which is essentially providing the government with an interest free loan for the year.
RRSPs are also designed with the objective of long-term investing. The very nature of this type of investment vehicle is such that there is great incentive to avoid “dipping” into your savings. This encourages individuals to stay invested over the long-run and reap the full benefits of market activities. Remember, the tortoise wins the race.
Any income you contribute to your RRSP is not taxable until you withdraw it from your account. This means your investments can grow on a tax-deferred basis right up until your 71st birthday and fully benefit from compound growth.
Things to keep in mind with RRSP’s
· You have 60 days after the calendar year end to make an RRSP contribution and deduct that contribution on the previous year’s tax return. This usually results in a deadline on or around March 1st
· Generally your RRSP contribution limit increases by 18 per cent of your previous year’s earned income to a specific dollar maximum.
· If you did not contribute the maximum to your RRSP each year, the contribution room not used has been carried forward and is available for use in subsequent years
· The best way to determine your RRSP contribution limit is to look at your most recent Notice of Assessment sent to you by the Canada Revenue Agency after you file your tax return each year
Without Further ado, here are 7 key tips for RRSP planning:
1.) Maximize your contribution
The less tax you pay, the more money you will have working towards your retirement goals. Your RRSP is one of the most powerful ways to protect your investments from taxes. Not only do you enjoy an immediate tax deduction, but your earnings within the plan grow and compound on a tax deferred basis until you withdraw money from the plan.
· A $10,000 RRSP contribution
· Equals $4,500 in deferred tax savings
Remember – a $10,000 RSP contribution could equal $4,500 in tax savings (if you are in the 45% tax bracket)
2.) Spousal RRSP
In 2007, the federal government introduced the ability for couples to allocate up to 50% of their ‘eligible pension income’ from one spouse to the other for taxation purposes. This is called Pension Income Splitting and it could reduce a family’s combined tax bill. “Eligible pension income” is income the qualifies for the federal Pension Income Credit and includes periodic pension income plus RRIF income where you have attained age 65.
A Spousal RRSP is an RRSP for the benefit of one spouse, but the contributions to the plan are made, and deducted, by the other spouse.
Spousal RRSPs are a good strategy if you expect one spouse to be in a lower tax bracket in retirement because they provide the benefit of balancing retirement income between spouses.
3.) Make “tax efficient” deduction decisions
You may not realize that if you expect to have a significantly higher income in the coming years, you can defer taking the tax deduction this year. Make the contribution now but take advantage by claiming the deduction when you’re in a higher tax bracket.
10,000 RRSP contribution @ 29% tax rate
$2,900 in tax savings
$10,000 RRSP contribution @ 45% tax rate
$4,500 in tax savings
4.) Go for growth
Often by playing it safe financially, you think you’ve protected yourself from investment losses. Think again. Sometimes the price of playing it safe is the erosion of your money over time thanks to inflation.
Certain investments often thought of as being safe may not keep pace with inflation, especially after considering taxes. The best way to ensure your investment stands the test of time is by investing in a diversified portfolio.
A diversified approach should include exposure to higher yielding equity mutual funds. If your portfolio is appropriately diversified and tailored to your time horizon and emotional tolerance for volatility, you will ultimately be playing it even safer over the long run.
5.) Tax-Efficient Investing
All investment income earned inside an RRSP compounds on a tax deferred basis, but once withdrawn from your RRSP it is 100% taxable. This includes realized capital gains and dividends.
o Interest income, which is earned from investments such as bank accounts, GICs and Money Market Funds is 100% taxable – the same as withdrawals paid out from your RRSP.
o Eligible Dividend income – which are profits paid out to shareholders of public corporations resident in Canada, non-Canadian controlled private corporations, and Canadian controlled private corporations subject to tax at the general corporate rate (i.e. not eligible for the small business deduction) – are tax preferred. Generally dividend income gives the best tax break if you are in the lowest federal tax bracket.
o Capital gains is the profit you receive when you sell a “capital property” such as a mutual fund for more than its cost. With capital gains you are only taxed on half of the increase in value. These are also tax-preferred.
If you have both RRSP and non-registered investments, it makes tax sense to hold your interest bearing investments inside your RRSP – since they are 100% taxable anyway – and hold investments that produce dividends and capital gains outside your RRSP. This strategy must be implemented to ensure that your overall asset allocation plan remains in place – so it’s important to discuss this with your financial Consultant.
6.) Resist “Dipping” Into your RRSP
Usually there is nothing to prevent you from accessing the investments in your RRSP (with the exception of ‘locked in’ plans). However, you should consider the consequences before you do it.
First of all, withdrawals attract tax at your marginal tax rate. Tax withholding at the time of the withdrawal may be as low as 10% but could be as high as 30%. You need to check with your tax advisor before you withdraw to determine how much more tax you’ll have to pay when you file your tax return.
Secondly, you cannot restore the contribution room. The amount that you can contribute to an RRSP in your lifetime is limited. A withdrawal erodes some of this potential.
7.) Start Early
When Jim turned 22 he began investing $2,000 per year right up until the age of 30. That’s nine $2,000 installments. When he turned 30, he decided to stop contributing to his RRSP and simply let the accumulated money in his account sit untouched until retirement.
Bob on the other hand started investing when he turned 31 years old and began investing the same amount as Jim, $2,000 per year, but he continued to contribute this amount right up until retirement at age 65. That’s thirty-five $2,000 installments, nearly four times as many as Jim!
As you can see even though Jim invested only approximately a quarter of the amount Bob invested, his investment grew $26,601 more, due to the effects of compound growth.
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