RRSP Tips and Traps – part 1

We are now well into the 2013 RRSP season, where many turn attention to the fact they haven’t or should be making an annual RRSP contribution.  I have put together a 2 Part Blog on RRSP that I hope people find informative when they consider their RRSP contributions for the current and future years.  Part 1 is about the initial tax savings and tax deductions.  Part 2 will come out later this week and lists a series of other tips and traps to consider when making your annual RRSP contributions.

Tax Savings

Why do we do RRSPs?  A few reasons generally, but most often cited is: I need the tax deduction on my return!

How much tax we can save with an RRSP contribution depends on what marginal tax rate we are facing.  The marginal tax rate is the rate of tax that an individual incurs on each additional dollar of taxable income they earn.  It is not to be confused with the average tax rate, which is the rate of tax an individual pays on their entire taxable income.  Our tax structure is incremental in nature:  the more we make in taxable income, the higher tax rate we pay, but only on the additional taxable income.

For example, a person making $70,000 has an average tax rate of ~21% (ignoring extra tax credits or deductions, they will owe approximately $15,000 on this taxable income – $15,000 / $70,000 = ~21%).  While the average tax rate is ~21%, this person is in the 29.7% marginal tax rate in British Columbia for 2012 and 2013.  Therefore, a $5,000 RRSP deduction could save this person a maximum of $1,485 ($5,000 x 29.7%).

So if you want to know how much you are going to save with your RRSP contribution, you need to know your marginal tax rate.  Here is a marginal tax rate schedule compliments of taxtips.ca (http://taxtips.ca/taxrates/bc.htm).  All calculations in this part of the blog are compliments of using the taxtips.ca website!  However, seek proper tax advice prior to making any RRSP contributions for tax purposes.

Contributions in the first 60 Days of 2013

Any contributions you make to an RRSP in the first 60 days of a calendar year (e.g January 1st to March 1st  of 2013) can be deducted either on the prior calendar year’s tax return (e.g. 2012), or in current year’s tax return (e.g. 2013).  As you might suspect, most people at this time are interested in taking the RRSP deduction in the prior year’s return, to help offset taxes payable or increase a tax refund coming this April.

However, if is ultimately your choice when you deduct the RRSP contribution.  In other words, the contribution to an RRSP is one thing, the deduction is another.  If you so chose, you could defer taking the tax deduction in the current and prior year, and carry the deduction forward to 2014 or later.

What should drive our decision on when to take the deduction?  The marginal tax rate I’m saving!  If I am in a higher marginal tax rate in 2013 versus in 2012, I might wish to take the deduction in 2013.

This may be hard to estimate for some people, but for others it can be straight forward.  For example, if I was working part-time in 2012 and full-time in 2013, I may have an advantage to take the RRSP contribution in 2013.  If I was working full-time in 2012 and retired in 2013, I may have an advantage to take the RRSP contribution in 2012.  If I expect to make similar income for the next few years, but I am planning to sell property in 2014 at a considerable taxable gain, then I might want the RRSP deduction in 2014.

So the main lesson here is – know your marginal tax rates!  Then you know if deducting your RRSP for 2012 is the right choice!

Tax Savings or Tax Deferral?

Bear in mind that ultimately you will be withdrawing from your RRSP, and when you do it will be taxable income to you.  So the current tax savings is important, but given you will ultimately pay taxes in the future on the RRSP withdrawal we should look at the RRSP as a combination of tax savings and tax deferral.  Tax deferral means instead of paying taxes now, I will pay them later.  A tax deferral can be very powerful, as you can grow assets in a tax deferred environment generally more quickly then you can in an environment that forces annual taxes payable.

Generally, you will accomplish a tax savings and tax deferral with an RRSP.  Why both?  Because you will generally be in a lower marginal tax rate when the time comes to start withdrawing your RRSP (e.g. at retirement).  In this case, you will pay some taxes on your RRSP withdrawal (tax deferral), but you will pay a lower marginal tax rate on the withdrawal than what you saved on the contribution (tax savings).

Spousal vs. Spouse

When making an RRSP contribution, know whose RRSP room you are using and who will ultimately be taxed on the RRSP withdrawal.

If you contribute using your RRSP contribution room, but you spouse will be taxed on any future RRSP withdrawal, this is called a Spousal RRSP Contribution.  In a Spousal RRSP Contribution, you get the tax deduction (subject to having RRSP contribution room, of course).

If you contribute using your Spouse’s RRSP contribution room, and your spouse will be taxed on any future RRSP withdrawal, this is your Spouse’s RRSP Contribution.  In a Spouse’s RRSP Contribution, your Spouse is getting the tax deduction (subject to having RRSP contribution room, of course).

One other thing to be aware if you do Spousal RRSP Contributions – the 3 Year Rule!   If your Spouse withdraws from a Spousal RRSP in the year of a contribution made by you, or two years thereafter, then part or all of that RRSP withdrawal will be taxable in the contributor’s hands.  This tax rule was put in place to avoid short-term planning to get a higher income spouse an RRSP deduction and a lower income spouse an income inclusion in a short period of time.  So if you plan to use a Spousal RRSP Contribution strategy, make sure you are up to speed on the 3 Year Rule!

Over-Contributing

One last comment on RRSPs and tax savings – don’t over-contribute!  Your last year Notice of Assessment from Canada Revenue Agency highlights your 2012 RRSP limit.  If you go over this limit, your over-contribution may face penalties of 5% and interest of 1% monthly!  Check out the CRA website for further details – http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/rrsp-reer/cntrbtng/xcss-eng.html.

If you have any questions, send me a message at marco@mgfadvisory.ca.