RRSP: When and Why you need them

Tax season is just around the corner, and that means RRSP contributions need to be made in the near future. Maybe you’re a bit of a procrastinator, but don’t wait too long, the RRSP contribution deadline is March 2 this year.

You may have never contributed to an RRSP in the past, you may not have even heard of them before. Well, it’s a good thing you found this article. We are going to look at what an RRSP is and help you to figure out if contributing to one is best for you.

Whether you are just entering the workforce or nearing retirement age, planning for the future is critical.

Ron Lewis

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So what is an RRSP?

Registered Retirement Savings Plans, are tax-sheltered savings accounts. Unlike some pension plans, RRSPs are self-established. They can either be established for you or your spouse. When established for a spouse they are called Spousal RRSPs.

You can set up an RRSP through most financial institutions such as banks, credit unions, trust companies, and insurance companies. If you would like to inquire about is involved in opening an RRSP in our office just fill out this form.

Contributions to an RRSP are made with Pre-Tax income. This means any contributions made can be claimed as a deduction against taxable income in the tax year the contribution was made, or the following 60 days (i.e., contributions for the 2019 tax year must be made by Mar 2, 2020).

Below we look at the following topics in regards to RRSPs in more detail: Contributions, Withdrawals, Receiving Income, Spousal RRSPs, Transfers, and Tax Benefits.

RRSP Contributions

In order to contribute to an RRSP, you must: be under age 72, have available contribution room, and file income tax in Canada.

People under the age of 18 can also open an RRSP. However, they must obtain signed permission from a parent/guardian who acts as the signing authority until the child turns 18.

Due to the great tax benefits of RRSPs, the Canadian government has capped individual contribution amounts. An individual is able to contribute the lesser of 18% of gross income or $26,500 in any given year. This means that the maximum income that is eligible for RRSP contribution room in 2019 is $147,217.

It is not just employment income that increases your contribution room. Earned income that increases contribution room includes the following items:

Any unused contribution room accumulates and can be used in future years. We will look at this again later.

As noted earlier, contributions are made with pre-tax dollars. In addition to that, the funds continue to grow tax-free as well. Tax is paid on any contributions and growth when the funds are withdrawn. Contrary to popular belief, contributions can be made at any point throughout the year.

RRSP Withdrawals

Once you have contributed money, there are specific circumstances where withdrawals are eligible and rules that apply.

One of the most common reasons to withdraw money from an RRSP is through the First Time Home Buyers Plan (HBP). This plan allows eligible first time home buyers to withdraw up to $35,000 tax-free from their RRSP to purchase their first home.

Any amount withdrawn under the plan must be repaid within 15 years. Repayment begins 2 years after withdrawal (i.e., withdrew money in 2018, repayment starts in 2020). When repayment starts, CRA will send you a statement specifying the amount that must be repaid that year. For more info on the Home Buyers Plan, click here.

There are other ways to withdraw money from an RRSP besides the HBP. A person can withdraw money from an RRSP for any reason. However, we strongly caution against this, except for some extenuating circumstances.

If money is withdrawn from an RRSP, that contribution room is lost. Unlike a TFSA, where withdrawals can be re-contributed the following year. Furthermore, because the contribution was originally made with pre-taxed dollars, taxes are withheld on the withdrawal.

Receiving Income

No one is permitted to have an RRSP after their 72 birthday. This means that at some point in your 71st year, you will have to convert your RRSP to an RRIF (Registered Retirement Income Fund).

Although you cannot have an RRSP after age 71, you do not have to wait till age 71 to convert it to a RRIF. Conversion can happen at any time.

Once you have converted your RRSP to a RRIF, minimum annual amounts must be withdrawn in the year following conversion. This means that if you converted it in 2020, minimum payments would begin in 2021.

Minimum payments are calculated based upon your age or the age of your spouse. Below is a table outlining minimum percentage withdrawal based on age:

AgeWithdrawal %AgeWithdrawal %
552.86%765.98%
562.94%776.17%
573.03%786.36%
583.13%796.58%
593.23%806.82%
603.33%817.08%
613.45$827.38%
623.57%837.71%
633.70%848.08%
643.85%858.51%
654.00%868.99%
664.17%879.55%
674.35%8810.21%
684.55%8910.99%
694.75%9011.92%
705.00%9113.06%
715.28%9214.49%
725.40%9316.34%
735.53%9418.79%
745.67%95 +20.00%
755.82%

The minimum amount must be withdrawn every calendar year. However, any amount above the minimum can be withdrawn. The only thing to remember is that tax will be withheld on all payments and payments will be recorded as income.

Spousal RRSPs

Earlier we mentioned the use of Sp. RRSPs. Instead of contributing to an RRSP in your own name, spouses can contribute to a Spousal RRSP. This entails opening a designated Sp. RRSP not just contributing to your spouse’s RRSP.

Sp. RRSPs can come in particularly handy when there is a large income discrepancy between spouses. For instance where one spouse is an extremely high-income earner, or where one spouse is a home-maker.

Using a Sp. RRSP allows the higher-earning income spouse to claim the income tax deduction while at the same time ensuring retirement income is more evenly split. Contributions to a Spousal plan still go against the contributing spouse’s eligible contribution room.

For example, if spouse “A” has the max annual contribution room ($26,500) they may choose to contribute $13,250 to an Sp. RRSP. This means that Spouse “A” now has $13,250 of contribution room remaining. Furthermore, when the funds are withdrawn during retirement they will be taxed in the hands of Spouse “B”.

Note that there are some rules and circumstances that dictate whose hands the funds are taxed in when they are withdrawn. The most notable of such rules is the attribution rule. This rule states that if contributions made in the current tax year or the prior 2 years are withdrawn, they are taxed in the contributing spouse’s hands.

Transferring an RRSP

Once an RRSP is opened at a particular institution, it can still be transferred. As long as you are transferring it from one RRSP to another there will be no baring on your taxable situation, and no contribution room will be lost.

When the holder of the RRSP dies, the proceeds can bypass probate. Bypassing probate only applies if an eligible beneficiary is designated. This includes spouses, minor children, financially dependent children, or disabled children.

RRSP Tax Benefits

When contributions are made to an RRSP or Sp. RRSP, they are a tax-deductible expense on your income tax return. So what does this mean?

This means that contributions directly lower your taxable income. Let’s say that your taxable income for 2019 was $95K and you contribute $10k to an RRSP, your taxable income drops to $85K.

Below we look at an example of how all the information discussed above might look in a given situation.

Example #1

Bob and Sarah and a middle-aged couple living in Manitoba. Sarah is a high-income earner making $220,000. Sarah’s husband, Bob, is currently a homemaker and has a taxable income of $0. Due to the large differences in income, Sarah opens an Sp. RRSP for Bob. The couple has 3 different RRSPs: Sarah’s RRSP, Bob’s RRSP, Bob’s Sp. RRSP.

Sarah sat down with her accountant, and they decided that Sarah should contribute the max ($26,500) for 2019. Sarah and her accountant decided it would be most beneficial to put $13,250 into each Sarah’s RRSP and Bob’s Sp. RRSP.

By doing the above contributions, Sarah’s new taxable income is $193,500. These two RRSP contributions would have given Sarah tax savings of $12,471.09, calculated as follows: $80,270.99 (taxes owed on $220,000 in MB) – $67,799.90 (taxes owed on $193,500 in MB) = $12,471.09 (total tax savings).

Note: this tax calculation assumes that tax rates did not change and were at the 2020 level in previous years.

What if Sarah had gifted the money to Bob?

A potential alternative to Sarah contributing to an Sp. RRSP would have been for her to gift money to Bob. Bob could have then, in turn, used that to contribute to his RRSP if he had available contribution room.

However, there are several drawbacks to doing this. First, the tax benefit would have been lower if Bob had contributed the $13,250 in his own name. This is because Bob’s marginal tax rate is effectively 0% because he did not have any taxable income in the year.

Secondly, if Sarah had not taken back anything for the $13,250 she gifted Bob, an attribution rule would apply. In this situation, when Bob withdraws the money that $13,500 and any corresponding growth, will be taxed in Sarah’s hands.

Sarah would actually have to “lend” Bob the $13,250 to make the spousal contribution, or take back something of equal value.

Future Withdrawal

Let’s assume that for the last 10 years Sarah and Bob and have done the exact same contributions to their RRSPs. This means that each of the RRSP and the Sp. RRSP have $132,500 of contributions.

Now let’s say that for some reason, in early 2020 Bob needs to withdraw $50,000. In whom’s hands would that withdrawal be taxed?

You might assume that Bob pays the tax on the withdrawal, and that would make you only partially right. Part of the withdrawal will be attributed back to Sarah. The attribution rule works as followed in this scenario:

Because contributions have been made in the past 2 years and in the year of withdrawal, $39,500 of the withdrawal is attributed back to Sarah. The remaining $10,500 is taxed in Bob’s hands.

The attribution rule states that withdrawals are taxed in the hands of the plan holder except for contributions made in the year of withdrawal and the two prior years.

For another practical example of how the information above could apply to a particular situation read: RRSPs in 2020.

Conclusion

RRSPs are a great tax shelter for retirement savings. Whether or not you should be contributing to one is another question. Although a lot of people know about RRSPs, few know all the intricacies that go with them.

Maybe you are unsure if you should be contributing to your RRSP, or a Sp. RRSP. Maybe you know you should be, but you have opened one yet. Whatever the case is, contact us! We would love to sit down with you and get a better understanding of your situation and your goals. The first meeting is always complimentary!

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Disclaimer: This Forbes Wealth Blog is for informational purposes only and does not constitute financial, legal, or tax advice of any kind. Please consult your legal, accounting, tax, investment, banking, and life insurance professionals to get precise advice relating to your particular situation before acting upon any strategy

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