February 2012

Your RRSP in 10 questions

  1. Why contribute to an RRSP?Why contribute to an RRSP?
    If you answered “to save on income tax,” you are partly right. Actually, you might even be wrong! The real advantage of an RRSP is that it allows your money to grow without your having to pay any tax on it for decades. That tax-sheltered compound return gives you remarkable financial leverage.

    But what about the tax deduction? See Question 2.

  2. How much income tax does my contribution save me?
    People often mistakenly believe that their income tax is reduced by the amount they contribute to their RRSP. In fact, your contribution reduces your taxable income. What you actually save is the amount of your contribution multiplied by your marginal tax rate. For example, if you contribute $2,000 and your tax rate is 30%, you will save $600 in taxes.

    So is it really worth it? See Question 3.

  3. Is it better to contribute to an RRSP or to a TFSA?
    Contributing to an RRSP saves you some income tax immediately. But any withdrawals that you make from an RRSP, including accumulated earnings, will be fully taxable. When you contribute to a TFSA, you don’t get a tax deduction in that year, but you pay no income tax on later withdrawals, including earnings. You would want a TFSA if your tax rate is likely to be higher when you withdraw your money than it is now (e.g. if you are young and just starting out), otherwise those later withdrawals will cost you more in income tax than your contributions will save you. But if the opposite is true, and your current tax rate is higher than what you expect in retirement, an RRSP would be a better choice.

  4. What if I contribute less than the maximum allowed?
    If you don’t use your full contribution room in a given year, the unused portion is automatically carried forward to any future year, indefinitely, right until the RRSP expires. That’s why it’s a good idea for young people to start filing income tax returns as soon as they begin earning, even if they have no taxes to pay: starting early allows them to build up contribution room.

  5. I have accumulated a large amount of contribution room carried forward from previous years. What should I do?
    Try to take advantage of a year in which your income is particularly high, and then make a big catch-up contribution. Since your tax rate will be higher that year, the amount of tax you save will also be higher. In some cases, particularly when interest rates are low and markets are depressed, it can even pay to borrow in order to make your maximum contribution. Always consult your financial services professional to make sure this is a good strategic move.

  6. Is it a good idea to use my RRSP to repay short-term debts?
    Usually not. Generally speaking, the income tax you’ll have to pay on the money you withdraw will be higher than the interest on your debt. But more importantly, the money you take out can’t just be “put back” into your RRSP: the corresponding contribution room will be lost forever. On the other hand, withdrawing funds from a TFSA creates an equivalent contribution room in the following year.

    There is one exception regarding an RRSP, and that’s if you withdraw funds under the Home Buyers’ Plan (HBP). See the next question.

  7. Can I use my RRSP funds to buy a home?
    Yes, and that is often an excellent idea. Under the Home Buyers’ Plan (HBP), first-time home buyers may use their RRSP to purchase or build a home. Individuals may withdraw up to $25,000 in a calendar year, and couples, up to $50,000. In order to qualify, neither spouse may have owned a home in the previous five years. Funds withdrawn must be repaid to the RRSP within 15 years.

  8. It is better to contribute to an RRSP or pay off a mortgage?
    Why not do both? We would all do well to pay off our mortgages as quickly as possible and also save as much as we can for retirement. One good way is to contribute to an RRSP and use the tax refund to pay down the mortgage. But with mortgage rates currently at an all-time low, it would be a good idea to review your strategy with your financial services professional.

  9. I have contributed a significant amount to an RESP, but my child is not planning to go to college. Can I transfer the money to my RRSP?
    If you have unused contribution room, yes. You can transfer the capital you contributed to the RESP plus up to $50,000 in investment earnings to your (or your spouse’s) RRSP. However, you would have to repay any grants you received in the RESP. Other conditions also apply.

  10. Should I contribute to my spouse’s RRSP?
    For a long time, this was the only way for a couple to split their retirement income in order to reduce their total income taxes. But it became less necessary for many couples when new regulations regarding income splitting were introduced a few years ago. Still, it might be a useful strategy. The only way to know is by speaking to an expert.

    Which brings us back to the number one rule when it comes to retirement savings: always consult your financial services professional!