Your RRSP questions answered

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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.

Should we start investing in RRSP or should we go ahead and focus on paying out the mortgage? —Dan

A. See the answer to Warren’s question above. You probably should put a priority on building up $30K-$40K in RRSPs to get the habit started and establish an RRSP “emergency fund”, which could be used to make mortgage payments and keep your house in the worst case where income dropped for an extended period.

Q. If one spouse earns over $100,000 and is not self-employed and the other is self-employed but earns only $30,000, can the income be split between the two to play less tax? —Terry

A. In Canada, income taxes are filed individually, which means that you cannot split the incomes to pay less tax. RRSPs, including spousal RRSPs, will not help in splitting income tax before retirement.

Q. We are one-income family. The spouse is a homemaker. Our gross income is $68,900, net income is $63,500. Is it better to contribute $1,000 to our RRSP (getting a tax savings of $320) or pay down towards mortgage? —Sher Kasmani

A. See the answer to Warren’s question above.

Q. I would like to know if one makes $66,000 in 2010 and paid the regular amount of income taxes, how much RRSP contribution needs to be made in order not to eliminate a balance owing on my 2010 tax return? —Yvonne

A. If your employer deducted the appropriate amount of income taxes (based on a $66,000 income), you should not owe any additional taxes when you file your tax return. But if, for example, your normal income was $50,000, and $16,000 came from overtime or a bonus, it is possible that amount deducted for the overtime or bonus does not properly reflect your actual income at the end of the year, and thus you may have a small refund or balance owing. A tax preparation service or software can give a better estimate of the tax due for your specific situation, as there are many other factors beyond the gross income you earned.

Q. When does it make sense to keep investments out of a registered plan? We have individual stock, which my financial advisor suggests can be registered, but should they incur a loss, we wouldn’t be able to claim that as a loss if they are registered. They are fairly safe/conservative stocks and I’m reluctant to forgo the tax return for a potential drop in the value , which may never occur. —Carla

A. This is another great question that is relevant to every RRSP investor who invests in equities. As you know, the ability to claim a capital loss is lost if you shelter equity investments inside an RRSP (or TFSA). To provide a comprehensive and thus meaningful answer, there are several parameters that should be accounted for.

The RRSP refund strategy used, reflecting your discipline level, is always a factor when contrasting RRSPs against unregistered investing or TFSAs. Do you spend the RRSP refunds, reinvest 100% of them, or invest using a “grossed-up” strategy (see Karen’s question, 3rd one)? Not using RRSPs eliminates the behavioural risk of not doing something productive with the RRSP refunds.

Clearly, the magnitude of equity returns is important. If the total return over the investment period is negative, then it is obviously better for these investments to not be sheltered, as you would then be able to claim a capital loss to reduce taxes. If returns are positive but low, say 2%, then the tax deferral benefit of RRSPs is very low. Here again, keeping equities unregistered is probably better because of the preferential tax treatment on dividend income and the fact that amount invested can be withdrawn tax-free and you only pay tax on 50% of any capital gain. (For Ontario tax payers earning less than $37,000 in 2010, the effective tax rate on eligible dividend income is about -6%, meaning the tax credit is greater than the tax due. See for more details).

If your equity returns do better, say averaging 10% annually, the question is tougher and requires more parameters and some number crunching. In addition to knowing the RRSP refund strategy used, we need to know if future withdrawals are in the same, higher, or lower tax brackets. Using RRSPs to defer taxes to when the tax rate is lower is an advantage that can’t be achieved with an unregistered or TFSA approach. The tax efficiency of the equity investment used is also a factor. What portion of the return is dividends? What amount of capital gains are deferred versus taxable annually? Closeness to retirement is also a factor.

Can equities be better unregistered? Yes, especially if you are close to retirement, the tax rate stays the same or goes up, and the investments are tax efficient. If RRSP refunds are spent, you might generate more after-tax retirement income keeping your equities unregistered regardless of the other factors.

I hope I have outlined some of the considerations. A more detailed personalized analysis is required to truly determine which approach is best for your unique situation.

For those interested in even more details about this, see my Investment Executive article on “Equities in or out of an RRSP?

Q. Which is more beneficial in the future for my retirement? I’m 31 years old and currently contributing the maximum for my RRSP and also on the defined benefit pension plan in the company I work for. I used to be a contributory member for the DB plan but I stopped doing it because it lowers my contribution limit for the RRSP. Which is better between the two? —Ali

A. Defined Benefit pension plans have some advantages that individual investors cannot achieve on their own. They can pool investments from many people over long time periods so that the impact of any single negative event, like a market crash, has less of an impact. Secondly, with the DB form of pension, it is the company’s responsibility to deliver the “defined benefit”, regardless of how well the investment markets perform. Unless there is concern about your company not sufficiently funding the DB plan in the future, most Canadians will prefer the “guaranteed” retirement income of a DB plan. Opting out allows you the freedom to invest more on your own in RRSPs and if you are a good investor and lucky, you could do better, but most won’t.

Q. If I retire and get income from my personal RRSP savings and or company pension, will I be denied government income from CPP or OAS? Just wondering if its better to focus on a TFSA before a RRSP. —40 Something

A. The Canada Pension Plan (CPP) is a government organized pension that is funded by contributions made by both you and your employer. Your CPP pension is 25% of your average pensionable earnings while you are working, with a maximum payout of about $960 per month, if started at age 65. Old Age Security (OAS) is a separate pension funded out of general tax revenue, and pays out about $525 a month. If your taxable income after age 65 is above about $68,000, your OAS income is clawed back or reduced by 15 cents for every dollar of income. If your retirement income might be between $68,000 and $110,000 (when the OAS is all gone), the OAS clawback is a factor in favour of investing in TFSAs instead of RRSPs.

See my answer to Warren’s question above for more details about RRSPs vs. TFSAs vs. paying down debts.

Q. My employer is offering a $150,000 company buyout. Am I able to top up my RRSP contribution to my plan as well as my wife’s spousal RRSP plan to avoid paying tax on this money? —Guest

A. Your HR department is better able to inform you how much, if any, of a buyout can be transferred to an RRSP. It depends on when you worked and pension contributions made before or after specific dates.

Q. When should my husband and I withdraw from our RRSPs, which have now grown to over $1,100,000? We are both retired (age 60) and will receive small taxable incomes (from a pension and part-time work) totalling $30,000 annually over the next 5 years, until deferred job pensions start at age 65, at which time we will receive $80,000, annually. (We both have gaps in CPP contributions and are considering waiting until age 70 to begin withdrawals.)

We need at least $75,000 annually to support our lifestyle. Over the next 5 years, we can supplement our low taxable income of $30,000 by drawing upon funds in non-registered accounts ($296,000), or we could whittle down our RRSPs to reduce the tax burden at age 65, when we start drawing larger job pensions. Alternatively, are the growth opportunities so beneficial inside an RRSP we should leave them untouched for as long as possible? What would you advise? At a modest growth of 8% per year our RRSPs could reach $1,710,700 in 5 years (but if our 22% rate of return for 2010 continues for just 3 years, it will exceed $2,113,000 very quickly).

Following is a summary of our financial situation:
RRSPS: me $632,300 all equities +husband $495,300 all equities
Non-Registered Investments (TSFAs, high-interest, equities): $295,808
Liabilities: 0
Material Assets (2 houses): Permanent $850,000 + Summer: $380,000
Other material assets (art, etc.): $100,000
Combined annual income over next 5 years: $30,000

Thank you for considering this question. —S.M.L.

A. Your lifestyle needs are completely met after age 65 by your pensions. Thus your implicit goal is to assess the best way to maximize your estate. I have analyzed scenarios similar to yours that indeed show that withdrawing registered funds early (before 65) in a lower tax bracket can net more after-tax retirement income later. So your idea of paying less tax now instead of more later has merit. However, since you might live to be 100 or more, the additional 20-30 years of deferred taxation using RRIFs could overcome the increased tax rate that your estate will surely face.

The details of your question indicate that you are both a sophisticated investor and value an accurate answer. I suggest you find an advisor who can analyze this for your situation, as a few more parameters are required. Without doing that, I would go ahead and withdraw from registered funds before 65 to meet your lifestyle needs (split between you and your spouse to keep your taxable incomes below the higher tax rates), and defer taking CPP if you both are healthy.

Q. If someone is currently going through a “Consumer Credit Proposal” or an undischarged “Bankrupcy” can they still do a transfer using a FSCOForm 5 under the “Full Withdrawal or Transfer of a Small Amount After Age 55”, transfering to an RRSP without losing the creditor protection and being forced to include the funds into their bankrupcy proceedings or consumer credit proposal? —Kevin

A. I am not familiar with the rules regarding Consumer Credit Proposals. The attorney or organization that is administering this for you should be able to help you answer this question.

Q. I’d like some clarity on spousal RRSPs. We both work, and my spouse makes substantially more than I. She also has a defined benefit pension plan and we’ve pretty much maxed out her available RRSP room. I, on the other hand, have $30K+ in contribution room and no pension plan from work. If we were to open up a spousal RRSP, whose contribution room is taken into account? —Henry

A. When you contribute to an RRSP, the maximum possible is based on your available RRSP room. Your next decision is whose name it should be in, your own, or your spouse’s. Assuming that you have little in your RRSP, to balance retirement incomes, your spouse should contribute to a spousal RRSP (thus using her contribution room), to build up your retirement income until it roughly matches her retirement income (from her pension and RRSPs).

Q. I have some questions about the Home Buyers Plan repayment. Is it repaid with after-tax money or pre-tax money? When you pay it back does it use the extra RRSP room you have accumulated? In other words, do you lose the RRSP room if you take the money out? Can you repay it right away if you have no more contribution room?

My situation: I will have enough cash for the down payment without using RRSP investment money. Would there be any benefit of taking the $25,000 out for the down payment only to put it right back in the next month to repurchase my investments? —1p

A. The RRSP Home Buyers’ Plan is repaid with after-tax money, which means that you don’t get a tax deduction to return the money “borrowed” from your RRSP. Repayment does not use any of your available RRSP room, but if you don’t repay it, the amounts are taxable as income and you never get that contribution room back. Thus repaying right away will not create additional contribution room, but it will ensure that the original amount withdrawn for the HBP continues to compound tax deferred.

If you withdraw from your RRSP for the HBP within 90 days of making the contribution, you may not be entitled to the deduction, so I suggest that you don’t use the HBP, since you don’t need it.

Q. How does borrowing money for your RRSP work for those in a high tax bracket? Is it worth it? —Heather

A. See the answer for Karen’s question (3rd one), above. Those in a higher tax bracket naturally produce a larger refund, which when immediately applied against the loan, leaves a smaller loan balance to be paid off. Thus, as you would expect, those in a higher tax bracket benefit more from borrowing for RRSPs (and borrowing to invest outside of RRSPs).

Q. We have been cautious in the purchase of RRSPs with the reasoning that when we draw from them after retirement, we no longer have many of the deductions that we might have at this point. How do we know how much RRSP we can invest and later draw without jumping into a higher taxable income bracket. —June

A. If you are in the very small group of Canadians who could end up in a higher tax bracket in retirement, congratulations!

To assess when you should stop adding to RRSPs to avoid retiring in a higher tax bracket, you will have to see a financial planner who can do a detailed retirement income analysis, obviously from an after-tax perspective. This is a newer and much more complex component of financial planning, and you might want to meet with 2-3 advisors for their analysis and hope for some consensus on the results. The advisor who best matches your comfort level, communication style, and need for detail might be the advisor you should be working with.

Q. How I can take my RRSP, which is all in a GIC in CIBC due June 30, and move it to a couch potato portfolio? Do I have to call BMO or CIBC and open up a Daily Interest RRSP and then move my money into it first? —Sean

A. If your GIC is cashable, you can cash it in and change it to any other eligible investment (including the couch potato portfolio) any time you choose. If it is not cashable, you might not be able to touch it until it matures on June 30. If there is a penalty to cash in early, you are probably better to wait until maturity unless you are confident that the couch potato portfolio will gain more than the penalty before June 30.

When you cash in any investment, it will become “cash” which will typically earn a very small interest rate, if any. Your financial institution will guide you through the process.

Thanks to everyone for their great questions. We’re no longer taking new questions.

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