To RRSP or Not To RRSP… you choose

It’s that time of year again when taxpayers contemplate if they will contribute to their RRSPs and, if so, how much?  RRSPs are one of the best ways to save for retirement.  Does it make sense to contribute this year?  Individuals without a corporate or government pension plan may feel more obligated to contribute to their own retirement.  Before making this year’s RRSP contribution we recommend that you take a good look at your overall financial situation.

Tax at 43.7 Per Cent

There are only a few ways in which Canadians can lower their taxable income – an RRSP contribution is one of those ways.   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 all of the income earned on those contributions compounds on a tax-deferred basis until they are deregistered.  For individuals in the highest marginal tax bracket it is almost always advantageous to contribute to an RRSP.  RRSP loans may even make sense even though the interest on the loan is not deductible.  Making an RRSP contribution may not make sense if cash flow is an issue, whether it is uncertainty around future income or other needs.

No Taxable Income

For individuals with no taxable income (under the basic exemption of $8,648 in 2005) we do not recommend contributing to an RRSP.  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.

Lowest Marginal Rates

Individuals that are in the lower marginal tax bracket but are expecting a significant increase in salary next year may be better off delaying an RRSP contribution.  If an RRSP contribution is made then the individual may be better off not claiming the deduction and carrying forward to the next year.  We recommend that individuals consult with their accountant, especially if their income is fluctuating.

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.  The two main exceptions to the rule are the Lifelong Learning and Home Buyers’ Plans.

Lifelong Learning Plan

RRSPs can help finance education costs.  Current rules allow a maximum withdrawal of up to $10,000 per year over a four-year period, as long as the total amount does not exceed $20,000.  Withdrawals must be repaid to an RRSP in equal instalments over 10 years or they will be treated as taxable income.  The first repayment is due 60 days after the fifth year following the first withdrawal.

Home Buyers’ Plan

Under the Home Buyers’ Plan you are allowed to withdraw up to $20,000 as a loan from your RRSP to buy or build a home, without counting the withdrawal as income.  You must then repay the loan, without interest, over the next 16 years.  To qualify you need to be a “first-time buyer” which is defined generally as not having owned and lived in a home as a principal residence at any time during the five calendar years up to and including the current year.

RRSP Contribution Room

RRSP contribution room is based on an individual’s prior year earned income. It is the lessor of 18 per cent of earned income or the maximum deduction limit.  Most individuals have carry-forward room from past years where they did not maximize their current year contribution.  Members of registered pension plans or deferred profit sharing plans will have their contribution room reduced by a pension adjustment.

RRSP Deduction Limits

In 2005, the maximum deduction limit was $16,500.  This limit was increased to $18,000 in 2006 and future increases will be linked to the growth in average wages.  You have until March first this year to apply contributions to the 2005 taxation year.  We encourage those investors that can contribute for the 2006 taxation year, do it now and not wait until this time next year.  Contributing early is an important element to compounding returns.

“In-Kind” Contributions

As a reminder, 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.

No More Foreign Content Limit

The 30 per cent foreign content limit in RRSP and registered pension plans is a thing of the past. Bill C-43, which was part of the 2005 Federal Budget, finally received Royal Assent July 2005. Canadian investors now have the option to invest up to 100 per cent of their retirement plans into foreign securities without penalty. The opportunity for money managers to seek out the best investment opportunities wherever they exist is wonderful news for Canadians, as it provides the opportunity for greater diversity and more attractive risk-adjusted returns.

When you meet with your financial advisor ask them whether an RRSP makes sense for you.  If you have sold a property or had additional income in 2005 we recommend that you contact your accountant to assess your overall tax situation.  If this is done prior to March 1, 2006, then a contribution to your RRSP for the 2005 taxation year may still be an option.