A Registered Retirement Savings Plan is not for everyone, but for those who are considering RRSPs or have them, it pays to head off some of the most common mistakes.
Prior to setting up an RRSP, determine whether you are likely to make one of the following 10 common mistakes:
1. Often people rush to make a last-minute RRSP contribution and give little thought to the underlying investment. Spend a few minutes to remember how long it took you to earn that money and slow the selection process down. Solution: If you are in a rush we recommend that you consider making contributions to your RRSP in cash and look at all your available investment options prior to making an investment decision.
2. Over contributing to your RRSP may result in T1-OVP penalties and interest. This past year we noted a campaign by Canada Revenue Agency that resulted in several letters being sent to individuals who have made over-contributions. Solution: Before you contribute to your RRSP, be certain of your limit.
3. Making contributions to an RRSP and pulling the money out before retirement. Often this results in more tax being paid than what you initially saved as a deduction. The shorter the time period between the contribution and withdrawal, the less likely you are to have received tax deferment of income. Contributing funds and withdrawing the funds uses up your contribution room, which is a big negative. Solution: Avoid contributing to an RRSP unless you can commit the funds until retirement.
4. People who have an RRSP account should understand that all income generated in the account is tax deferred. This is by far the biggest advantage of an RRSP. Over time, this should save you much more in taxes than the initial deduction for the contribution. People who have non-registered investments understand that income generated in these accounts is taxable. Pulling funds out of an RRSP prior to age 72 is generally the wrong decision when non-registered funds are available. There are some exceptions, such as shortened life expectancy. Solution: Using the capital within your non-registered investments first will reduce your current annual income and defer taxes further.
5. Some people have multiple RRSP accounts held at different financial institutions. They may have $10,000 at institution A from a 2004 RRSP contribution, $6,000 at RRSP institution B from a 2005 RRSP contribution, and $8,000 at institution C from a 2006 RRSP contribution. This may result in additional RRSP fees being charged to you and result in you paying more fees than you need to pay. More importantly, your investments become more difficult to manage. Solution: Consolidate your RRSP accounts at one institution for better management, to reduce fees, and to open up more investment options.
6. Underestimating life expectancy is also a common mistake. All too often people in their 60’s begin pulling money out of their RRSP solely to avoid paying a large tax bill if they were to pass away. We encourage people to plan for the most likely outcome rather than the worst-case scenario. Solution: Avoid early withdrawals and ensure that you take full advantage of the deferral benefits of your RRSP.
7. When you open an RRSP account you must make a beneficiary selection. If you are married or living common law then the natural choice is your spouse for the tax-free rollover provisions on the first passing. Often widows will still have their deceased spouses named as beneficiary. We have seen cases where people have remarried and have their ex-spouse still listed as a beneficiary. In some cases naming your estate may be the best option. Solution: Speak with your advisor and ensure you have the correct beneficiary on your RRSP account.
8. We encourage people to give careful thought to the type of investments they hold within their RRSP and outside of their RRSP. Good structure decisions are important and are easier when all of your investments are at one institution. To illustrate this we will use an individual that has equity investments within their RRSP that may generate dividend income and future capital gains (all income within an RRSP is treated as regular income for withdrawals). Let’s also assume that this same individual has GICs and term deposits at the bank that are not within their RRSP. Although this individual does not require income, he is being taxed every year on the income. Solution: Have interest generating investments within your RRSP along with equities that you may trade from time to time. Outside your RRSP consider investments that are long term holds that generate primarily capital gains. For non-registered accounts, Canadians are not taxed on unrealized gains until the investment is sold. If you purchased a basket of blue chip equities outside of your RRSP and held them for 20 years you would not be taxed on the gain until the investment is sold. In effect you have created two types of tax deferred plans.
9. People who do not have pension income (not including CPP and OAS) should ensure that they are taking all planning components into consideration before requesting early RRSP withdrawals. Withdrawals from an RRSP are not eligible for the pension income amount and they are not eligible for income splitting. Solution: If you require funds then we encourage you to wait until at least age 65 and then convert funds to a RRIF before withdrawal. RRIF income received at age 65 or older may be eligible to be split and qualify for the pension income tax credit ($2,000 each per year).
10. One of the biggest mistakes we see is failure to make an RRSP contribution. Individuals who are making large salaries without a pension need to take advantage of their RRSP contribution room. Not having the discipline to set aside funds for retirement will result in making sacrifices at retirement. Solution: Consider making an RRSP contribution.