Take three-step inventory before RRSP planning

Should you contribute to an RRSP?  Before maneuvering money in that direction, investors should complete these key steps:

Step 1 – Review your notice of assessment from Canada Revenue Agency for the 2005 taxation year.  Within this notice you should see a table that is titled “2006 RRSP Deduction Limit Statement.”  This table provides your RRSP deduction limit for 2006 and will note the dollar amount of any unused RRSP contributions.  Some individuals may find that they have no available room and therefore are not eligible to make an RRSP contribution.   Those who have contribution room should carefully review steps 2 and 3.

Step 2 – Obtain an understanding of your income for 2006, expected income for 2007 and future years.  This may include capital gains for sales of investments and real estate other than your personal residence.  In addition you should obtain an understanding of the marginal tax bracket that you are in.  The following outlines the tax savings for an individual making a $10,000 RRSP contribution with different levels of taxable income:

rrifs

No Taxable Income

For individuals with no taxable income we do not recommend contributing to an RRSP as there are no tax savings.  If a child or individual has earned income and they are under the basic exemption it may still be beneficial to file a tax return.  Filing a return will report the earned income, 18 per cent of which will be used to build up RRSP contribution room for the future.  One day when the individual has taxable income they will also have RRSP room they can take advantage of.

Lowest Marginal Rates

Individuals who are in the lower marginal tax bracket but are expecting a significant increase in salary next year may be better off delaying their RRSP contribution.  If an RRSP contribution is made then the individual may be better off not claiming the deduction and carrying forward the unused portion to the subsequent years when it is more advantageous.

Highest Marginal Rates

Those in the highest marginal tax brackets may benefit the most from RRSP contributions.  Canadian taxpayers have few ways to lower their taxable income – an RRSP contribution is one.  As illustrated above, individuals in the 43.7 per cent marginal tax bracket may reduce taxes payable (and possibly generate a tax refund) by $4,370 for a $10,000 RRSP contribution.   In addition to the tax deduction any potential growth within the RRSP compounds on a tax-deferred basis until they are taken out as a withdrawal.

For individuals in the highest marginal tax bracket it is almost always advantageous to contribute to an RRSP.  Short-term RRSP loans may make sense although the interest on the loan is not deductible.

RRSP Undeducted Contributions

A less understood fact about RRSP contributions is that you do not have to deduct them in the year they are made. RRSP undeducted contributions are contributions that you have made to your or your spouses RRSP for which you have not taken the tax deduction.

By making a contribution, you are able to take advantage of the tax deferred compounding within the RRSP. If you expect to be in a higher marginal tax rate in future years it may be beneficial to hold off on taking the tax deduction in the current year and carry forward this undeducted contribution to a future year. You will not be getting the benefit of this tax deduction until the future and therefore your current tax liability will be higher than if you took the tax deduction now.

Step 3 – Spend some time determining if the funds for the RRSP contribution will be kept within the plan until retirement.  The main questions to consider are:

  • By making an RRSP contribution will your cash flow be strained?
  • Is there significant uncertainty around current or future income?
  • Do you feel you will need to access your investments in the near future?

For all individuals, regardless of tax brackets, you need to weigh the benefits of contributing to an RRSP versus the likelihood that the contributions will not be touched until retirement.   We recommend that individuals consult with their accountant, especially if their income is fluctuating.

In-Kind Contributions

An RRSP contribution does not have to be made in cash. A contribution in-kind of securities that are already owned outside an RRSP gives the benefit of the RRSP deduction. At the same time the security continues to be owned.  Investors must, however, declare any capital gains accrued on the investment at the time of the transfer. If the investment is in a capital loss position, investors are not permitted to claim that loss unless the security is sold and then a contribution is made in cash.

Retirement

The majority of people do not take full advantage of the ability to maximize their RRSP contributions.  An alarming number of Canadians have a very low income at retirement.  Many have little more than CPP and OAS to subsidize their day to day living costs.  We encourage individuals to consider their retirement years when making financial decisions.

Contribute Early

Time has an amazing way of compounding investment returns.  Investors who establish a monthly pre-authorized contribution to their RRSP are more likely to be financially prepared for their retirement years.  The sooner people begin investing, the longer the savings will be able to grow on a tax deferred basis.

Last Day

The deadline to make your 2006 RRSP contribution is March 1, 2007.  Assuming you have the deduction limit we recommend that you take a good look at your overall financial situation and review the three steps above. You and your professional advisors have just over a month to assess whether an RRSP is right for you.