Thinking about contributing to a registered retirement savings plans (RRSP) before the annual deadline hits?
There’s good reason to circle the cut-off date (it falls on March 1 in 2021). It’s your last chance to make a contribution that’s deductible against your taxable income. This means it’s your chance to lower your tax bill (that’s based on the previous tax year).
That tax deduction is just one of many benefits RRSPs offer.
Another? Tax deferral. That means investments you hold inside your RRSP grow tax-free until you withdraw those funds from your account.
Sounds simple, right? But RRSP mistakes can still happen every now and then. Luckily, there are ways to steer clear of them or catch them before they become a problem. Cliff Steele, a certified financial planner with Sun Life Financial1 offers these expert tips to help you avoid 5 of the most common RRSP mistakes .
RRSP mistake #1: Only putting cash in your RRSP
Did you know you can hold many types of investments in an RRSP? This includes stocks, guaranteed investment certificates, mutual funds, bonds and more.
But here’s a common scenario. In a scramble to make the deadline, you contribute cash to your RRSP. Then life takes over and you don’t get around to actually investing the money.
“Remember, your money grows tax-deferred until you take it out. So you need to have growth assets [in your RRSP],” says Steele. “You may be holding a lot of cash because you’re short on time [to make a plan]. In such a case, it helps to talk to an advisor and find a way to invest those assets.”
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RRSP mistake #2: Making early withdrawals
Making RRSP withdrawals before retirement to, say, cover bills or make big purchases can have lasting consequences. For one, you're giving up the years of tax-deferred growth your money would have generated inside your plan.
And secondly, you’ll face a double tax hit.
The first comes on withdrawal. You’ll have to pay an immediate withholding tax. Here’s a look at just how much:
How much withholding tax will you have to pay for RRSP withdrawals?
|Withdrawal amount||Percentage of withholding tax in all provinces (except Quebec)||Percentage of withholding tax in Quebec|
For the first $5,000
5% federal + 15% provincial on a single withdrawal
For amounts between $5,000 and $15,000
10% federal + 15% provincial on a single withdrawal
For more than $15,000
15% federal + 15% provincial on a single withdrawal
And that’s not all.
“So let’s say your marginal tax rate is 35% and you took money from your RRSP at (a withholding tax rate of) 10%. Then you’ll still owe that other 25% in taxes,” explains Steele.
Steele’s advice? Use your RRSP as your option of last resort.
“I encourage people to look at other arrangements. Why? Because there’s no situation where [early] RRSP withdrawals are the best option,” explains Steele. “If your income is higher, you’ll pay 30% or more in taxes versus a credit line at, say, 2% interest.”
Is there any way to avoid the tax hit on early RRSP withdrawals? There is and it means withdrawing funds under the Home Buyers’ Plan or the Lifelong Learning Plan. These plans let you borrow cash from your RRSP for your first home or qualifying post-secondary education. But you must pay back the money you borrowed within a fixed timeframe.
RRSP mistake #3: Over-contributing to your RRSP
You can put up to 18% of your previous year’s earned income in your RRSP. That’s up to a maximum amount set annually. You can also carry forward room from previous years. (Your notice of assessment from the CRA spells all of this out in dollars and cents.)
That sounds like a lot of leeway, but Steele still sees people go over the line occasionally. Company pension plans or deferred profit-sharing plans (DPSPs) are usually the culprit.
“If you’ve contributed to a pension – defined-benefit (DB) or defined-contribution (DC) – it will decrease your contribution limit,” he says. “Contributions to a DB or DC pension, as well as to a DPSP [even though a DPSP isn’t a pension], show up in the form of a pension adjustment in box 52 on your T4 slip. Often, people who over-contribute have a pension or a DPSP and they didn’t realize that these decrease their RRSP room.”
It’s also important to note that you can over-contribute a lifetime total of $2,000 without penalty. The CRA allows the $2,000 as a buffer against possible errors like ones from a pension adjustment.
RRSP mistake #4: Spending (instead of investing) the tax refund
Your RRSP contributions may result in a tax refund. So what happens if you reinvest this cash in your RRSP without over-contributing? Then you can trigger a happy growth cycle for your nest egg, thanks to the magic of compounding.
"Let’s say you contribute your tax refund to your RRSP year after year [subject to the contribution limits]. Then your RRSP will balloon, and your refund will keep getting bigger,” says Steele. “By reinvesting it, you’re getting tax dollars back via refunded tax dollars from the prior tax year.”
But if you spend your refund instead, you’re missing a great opportunity.
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RRSP mistake #5: Misunderstanding the RRSP succession rules
Another common error happens when people name an adult child as their RRSP beneficiary when they still have a living spouse or common-law partner.
“What people often don’t realize is that RRSP assets transfer tax-free to [the RRSP of] a spouse at death. But payments made to [adult, non-dependent] children and others beyond a qualified spouse are taxable as income,” says Steele.
But what if you have no living spouse or partner and you leave your RRSP to your estate? You still can’t escape the tax bill. The CRA will add the fair market value of the assets held in your RRSP to your income in the year of your death. This can trigger a significant tax bill for your estate that could diminish its value for your heirs. However, that tax can be deferred (meaning you won’t have to pay it right away) if you died leaving:
- a financially dependent child or grandchild under 18, or
- a financially dependent, physically or mentally infirm child or grandchild of any age.
But don’t let that keep you away from RRSPs, says Steele. The key is to view your RRSP as a tool to sustain yourself in retirement, not to pass on a legacy.
“I always tell people that the idea is that they will prudently plan in retirement and slowly withdraw money as needed from their RRSP. They can later convert their RRSP to a RRIF, and whittle it down over time,” he says.
Remember, the RRSP deadline for 2020 is on March 1, 2021. The CRA allows contributions for the previous tax year for up to 60 days after year-end. If you aren't already contributing to an RRSP, consider setting one up to start growing your nest egg.
- Need help? An advisor can help you get started with setting up your RRSP. Most advisors now offer to meet Clients virtually by video chat. Find an advisor near you.
1 Cliff Steele, CFP,© BBA, BMath,† The Steele Group Financial and Workplace Services Inc., Sun Life Financial advisor.
† Mutual funds offered by Sun Life Financial Investment Services (Canada) Inc.
Sun Life Assurance Company of Canada is a member of the Sun Life group of companies.
This article is meant to only provide general information. Sun Life Assurance Company of Canada does not provide legal, accounting, taxation, or other professional advice. Please seek advice from a qualified professional, including a thorough examination of your specific legal, accounting and tax situation.