Newcomers to Canada can find themselves in straitened financial conditions with daily expenses quickly eating into savings.
Watching hard-earned money disappear while they search for employment, many believe they can’t possibly make contributions to Registered Retirement Savings Plan (RRSP). Also, with recent statistics showing that Canadians are carrying more debt than ever before, many feel it must be one or the other: pay down debt or save for retirement.
But take hope. According to experts, there are ways to save money and pay down debt at the same time. Having the best of both worlds is not as hard as you might think.
RRSPs help you save for retirement in the future, while giving you a tax break today. In the tips below, expert Chartered Professional Accountants discuss RRSP basics to help you get started on a secure financial future.
Q. Why is an RRSP a good idea?
A: “An RRSP helps you save for retirement while providing an immediate tax benefit when you make an RRSP contribution,” says Bruce Barran, a partner with Davis Martindale LLP in London, Ontario. “Ideally, you make RRSP contributions when you are in a higher tax bracket and withdrawals when you are in a lower one.”
RRSPs also accumulate compound investment income on a tax-deferred basis. “Government pensions are not enough to retire on,” Barran adds. “You need to plan ahead for retirement and RRSPs are a good retirement savings vehicle.”
Q. How do I start an RRSP?
A: “You can set up an RRSP through a registered financial institution such as a bank, through an investment broker or through a financial planner,” says Barran. “Your RRSP can include many kinds of investments, such as GICs, stocks, bonds, and mutual funds.”
When setting up an RRSP, you can rely on an advisor to choose and manage your investments, or take a more active role by setting up a self-directed RRSP.
Q. Should I put my money in an RRSP or a TFSA?
A: RRSPs provide tax deductions for amounts contributed (up to a certain limit) and allow earnings on your assets in the RRSP to accumulate tax-free. As well, the funds in your RRSP are only taxed when withdrawn, which can create significant savings if you withdraw the funds when your income and marginal tax rate are lower, such as after retirement.
You can contribute $5,000 per year since 2009 ($5,500 for 2013 and 2014, or, cumulatively $31,000 to date) to a Tax Free Savings Account (TFSA). TFSAs are more flexible than RRSPs because you can take money out without affecting your ability to use a TFSA again in future years. Contributions to TFSAs don’t give you a tax deduction, but when you withdraw money from them the accumulated contributions and income you receive are not taxable.
So which one should you put your money into?
“That really depends on what your marginal income tax rate is now, and what you expect it will be in retirement,” says Claudio Saverino, a senior tax manager with BDO Canada in Markham. “If you are in a high tax bracket now, and expect to be in a lower one later, RRSP contributions effectively move income that would be taxed at a higher rate now into a lower tax bracket later. This produces both a tax deferral and a tax saving.”
If you are in a lower tax bracket now, and expect to be in the same lower tax bracket later in retirement, a TFSA might make more sense than an RRSP. “This is because using an RRSP could put you into a higher tax bracket in retirement, while the deduction arising from the contribution now will be at the lowest marginal rate,” explains Saverino. “Also, having lower income in retirement may allow you to keep more of your government benefits that are income tested, such as Old Age Security.”
If you have funds now, but may need to use them before retirement, contributing to a TFSA temporarily may be wise.
“Contributing to an RRSP and withdrawing the funds soon after is not usually a good idea,” says Saverino. “Although the income and deduction may offset each other, if the contribution and withdrawal are in the same year, this still eliminates RRSP contribution room. In this situation, a better plan could be to put the money into a TFSA and then later withdraw and contribute the funds to an RRSP once you are sure you won’t need the money until retirement.”
Q. How much money should I put in my RRSP?
A: “You can contribute as much money as you want to your RRSP,” says Saverino. “However, there are limits on how much of your contributions are tax deductible and there is a penalty tax for contributions over these limits.”
While it is advisable to maximize your RRSP contributions, in order to accumulate sufficient funds for retirement you should generally limit your contributions to the amount that is currently tax-deductible.
“If you contribute more than your limit, you will be subject to a one per cent per month penalty tax to the extent that the over-contribution amount exceeds $2,000,” says Saverino. “This penalty tax is expensive, so it is not worthwhile to contribute above your limit.”
Generally, the limit for a year is 18 per cent of your previous year’s earned income, up to a maximum amount of $23,820 in 2013 and $24,270 for 2014. This amount is reduced by the previous year’s pension adjustment and Pooled Registered Pension Plan contributions and increased by any carry-forward contribution room.
Q. Should I borrow to put money in my RRSP?
A. “Generally speaking, I would advise against borrowing to make an RRSP contribution, unless the loan is temporary,” says Jean-Paul Lafrance, a tax partner with BDO Canada in Ottawa. “The interest you pay on a loan is not tax-deductible and the RRSP will be generating interest that will eventually be taxable. Unless the loan interest rate is very low, or you can repay the loan within the year, don’t borrow to make an RRSP contribution.”
Q. Should I put money in my RRSP or pay down my debt?
A. Deciding between an RRSP contribution and paying down your debt depends on many factors, especially the interest rate on your debt.
“If the debt is a high-interest rate loan, like a credit card, pay it down first,” advises Lafrance. “However, if your debt is a low-interest loan, like a car loan or a mortgage, it may make sense to put money into your RRSP. Just be sure to use any tax refund from the RRSP contribution to pay down your debt.”
Q. When should I start saving for retirement?
A. “The earlier you start saving for retirement, the earlier your money can start compounding and the longer you’ll have it working for you,” says Gregory Clarke, Partner with SB Partners LLP in Burlington.
“Contributions to an RRSP result in a tax deduction, which is a key benefit that people obtain with RRSPs. In addition, income earned within the RRSP is tax-free, but it is taxed when you withdraw it at a later date.”
To start an RRSP, you must have a social insurance number and earned income. The amount of your previous year’s employment income is used to determine your contribution room for the next tax year.
For 2015, each taxpayer’s annual contribution room is calculated as 18 per cent of their 2014 earned income, to a maximum of $23,820, less any required pension adjustments.
Also, any unused contribution room from previous years is carried forward, so the amount that you can contribute may be higher.
“The best reason to start an RRSP early is that it gets young people into the habit of saving,” explains Clarke. “Even if it’s a couple hundred dollars a year, it helps create a mindset that saving is important.”
To make an RRSP contribution to get a deduction on your 2015 personal tax return, you will need to make your contribution by March 2016.
Q. What is the cost of withdrawing money from RRSP?
A. If you withdraw money from your RRSP, here’s how it will affect you financially.
“If the withdrawal is $5,000 or less, you’ll be subject to tax of 10 per cent withheld at source; 20 per cent if the withdrawal is greater than $5,000 and less than or equal to $15,000; and 30 per cent for amounts greater than $15,000,” says Henry Korenblum, a manager in the tax group at Crowe Soberman LLP in Toronto.
Korenblum suggests that you consider several smaller withdrawals rather than one large lump-sum payment to reduce the tax withheld at the time of the withdrawal.
“The reduction is only a tax deferral, as the withdrawn amounts must be reported on your tax return where they will be subject to your regular tax rate,” he explains.
Keep in mind that in situations where a taxpayer makes a single request to withdraw an amount in installments, the withholding tax would be based on the total amount to be withdrawn.
– Courtesy: The Chartered Professional Accountants of Ontario