Your RRSP questions answered
You’ve got questions, we’ve got answers.
MoneySense has the answers to your RRSP questions. We were taking your questions all week, and now we present the answers from financial author Talbot Stevens.
Thanks to everyone who submitted questions. We are no longer taking new questions.
Q. I have unused RRSP contribution. Can I contribute, even though my only income is a government pension and a RRIF?—Judy Webb
A. If you have unused contribution room, you can contribute to an RRSP until the end of the year that you turn 71. If you have a younger spouse or common-law partner, you can contribute to a spousal RRSP until the end of the year that he or she turns 71.
“Earned” income (generally from employment or business activities) creates the contribution room, but is not necessary for using the contribution room carried forward from the past.
Q. RRSP contribution room for one year is based on the “earned” income of the previous year plus the carried over contribution room from previous years. If I want to estimate this year’s contribution room prior to receiving my Notice of Assessment, how would I do that? Is RRSP contribution room based on pre-tax or post-tax income? — Kevin
A. Your contribution room created for 2011 is based on your 2010 “earned” income, which you should now know from your employment (T4’s), business activities, and other sources like royalties, research grants and unemployment benefits. For full details on what is included in “earned” income, visit CRA’s web site. RRSP contribution room is based on pre-tax income.
Q. Should we get an loan to contribute to our RRSP? I am currently on maternity leave and I am concerned I may have to pay taxes. —Karen
A. First, be clear on your objective. Is your goal to not pay more taxes now, or is it to save for a secure retirement in the most effective manner? Some, like those in the lower tax bracket who will have a low income after 65 and receive GIS, are better offnot using RRSPs to defer taxation to the future, even if that means paying some tax now. This is because of the “hidden tax” of the GIS clawback which reduces payouts by 50%.
There are fundamentally 3 “borrow for RRSPs” strategies.
1. A “Gross-up” RRSP loan. Here you borrow the exact amount needed for the RRSP refund to completely pay off the loan almost immediately (a few weeks later when the refund comes back after filing your tax return). Example: If you’re in a 40% tax bracket and have $3,000 available, you could borrow an extra $2,000 to make a $5,000 RRSP contribution. This should generate a refund of $5,000 x 40% = $2,000, which is enough to completely, and almost immediately, repay the $2,000 “gross-up” loan.
2. A “Top-up” RRSP loan. The “top-up” loan strategy is where you borrow a modest amount that is completely paid off within a year, before next year’s RRSP contribution deadline. Example: If you have $3,000 available and want to contribute $10,000 this year, you could borrow $7,000. This would generate a $10,000 contribution and a $10,000 x 40% = $4,000 refund. The $4,000 refund can almost immediately reduce the $7,000 loan to $3,000, which is paid off before the following March.
3. A “Catch-up RRSP loan. This is where you borrow a larger amount to temporarily “catch up” on lots or all of your unused contribution room. Even after reducing the loan with the refund, the loan might take up to 10 years to pay off. Example: You have $25,000 of unused room. In a 40% tax bracket, you could borrow $22,000 to add to your $3,000 for a $25,000 contribution. The $25,000 x 40% = $10,000 refund reduces the loan to $12,000, which is paid off over say 10 years.
Assuming RRSPs make sense for you, you can’t lose using the “gross-up” loan approach, and almost everyone agrees that the “top-up” strategy is a good idea. Borrowing larger amounts for a “catch-up” strategy is more controversial because borrowing to invest is poorly understood and scary for most. Having done much research in the area of borrowing to invest, let me briefly suggest that the biggest benefit of a “catch-up” approach is that it can be a behavioural solution that locks in a higher level of discipline and commitment than most have. Once started, you don’t have a choice about paying off your RRSP loan, while too many of us spend our RRSP refunds, or “temporarily” skip contributing.
Note that for equity investors, any borrow-for-RRSPs strategy is less risky and more profitable when the market is down, allowing you to “buy more” when it is on sale.
Those interested in more details about borrowing for RRSPs can check out some of the Free Resources on my website, especially the Articles in the RRSPs section.
Warning: Only consider borrowing an amount that is financially and emotionally comfortable for you, which might mean none.
Q. In 13 years I retire with a Government Pension with between $50-65 thousand per year pension. What should I concentrate on? A TFSA, RRSP or just get my $250,000 dollar mortgage paid off? —Warren
A. This is a great question that is relevant to millions of Canadians who have any debt and/or have not maxed out both their RRSP and TFSA, especially now with average debt levels reaching record highs.
While you have given some information about your situation, there are many parameters that should be factored into an objective answer for what is the best strategy for your unique situation. To comprehensively prioritize these possible uses of money, some of the relevant factors to consider include:
• your discipline level (if you pay off your mortgage faster, what portion of that freed up cashflow actually gets invested?)
• interest rate on mortgage (debt)
• retirement funding shortfall (how much more is needed?)
• time to retirement
• retirement duration (how long must money last?)
• other assets and sources of retirement income (pensions)
• tax bracket now, and estimated tax bracket in retirement
• expected investment returns before and after retirement
• investment risk tolerance
• whether the current equity markets are really low (“on sale”)
Acknowledging that simple rules-of-thumb may be the opposite of what is best for any individual’s situation, I generally suggest that:
RRSPs should be avoided for those in the lower tax bracket and expect to retire in the lower tax bracket, and by those in the middle tax bracket who expect to retire in the highest tax bracket (by selling a business, etc.)
Theoretically, RRSPs and TFSAs produce the same tax efficiency if you retire in the same tax bracket as when you contribute. If your tax bracket will go down in retirement, deferring taxes using RRSPs helps more than TFSAs.
In practice, most people unknowingly invest less towards their retirement than they start out with, converting after-tax dollars into before-tax dollars, by spending their RRSP refunds. For example, if I’m in a 40% tax bracket and put $1,000 in an RRSP, I will get back a $400 refund. If I spend the $400 refund, the net (after-tax) contribution to my retirement is only $600, which is much less than the $1,000 (after-tax) amount I started with. This behavioural risk of RRSPs is avoided completely by directing the $1,000 into TFSAs or paying down debt.
Eliminate all debts before retirement. This doesn’t mean eliminating the mortgage before investing, as your goal is to hit retirement with no debts and the best-funded retirement possible.
Most middle-income investors are better off putting RRSPs ahead of paying down mortgages, mathematically and behaviourally, and for extra flexibility and short-term security. Paying off more expensive debts like credit cards comes ahead of everything. If mortgage rates are really high, over 7-8%, then this is generally better because it produces a guaranteed after-tax return of 7-8%, which is tough to beat.
Note that the common reply to the perennial “debt vs. RRSP” dilemma to “do both” by putting your money into RRSPs and using the refund to pay down your mortgage is a political response that doesn’t answer the question of which is better. If RRSPs are better initially, then they are still better a few weeks later when your refund comes in. Those who want a more detailed look into this can check out my Investment Executive article “Should your clients invest in RRSPs or pay down debt?”
Warren, without knowing more about your situation, I suggest you pay off your mortgage over the next 12 years, and invest any remaining cashflow per the above guidelines.
Q. Here’s my scenario: married couple, no kids, early 40’s, 4 years Canadian work history, annual household income before taxes $95,000. Current RRSP, investments = $0. All savings are going towards mortgage.