It’s that’s time of year again – RRSP season is upon us, yet the majority of Canadians are not properly educated on this investment vehicle and if it’s the best option for them. Everywhere we turn, we are constantly bombarded with advertising messages telling us to buy, buy, buy, and RRSP’s are no exception. How many of us take the time to really understand what we are purchasing?
Let’s review the basics: despite what we are often led to believe, RRSPs are not the actual investment; they are simply the registration of the account. It is the registration of the account that dictates how it will be taxed both when the money goes in, and when it comes out. The account itself can hold a variety of different types of investments, such as GIC’s, mutual funds, stocks, or savings accounts, to name a few. There are several rules surrounding RRSP’s that it is important to be aware of:
RRSP’s basic tax and withdrawal rules are:
- You are eligible for a tax deduction for the amount of money you contributed to your RRSP in that year. This can be up to 18% of our previous years income, to a maximum of $23, 820 for the 2013 tax year. For example, if someone earned $50,000 before taxes in 2013 and purchases $5,000 worth of RRSP’s on or prior to the deadline on March 3, 2014, they will pay income tax as if they earned $45,000 in 2013. (*allowable contribution amount will differ for someone who is contributing to a pension plan already).
- The growth within the RRSP is tax deferred. That is, no taxes are payable on the growth that may be earned until you start to withdraw your funds.
- When it does come time to take RRSP’s out, the amount withdrawn is taxed at your marginal tax rate at the time of withdrawal. Many retirees expect to earn less in retirement than they did during their working years, so the funds would hypothetically be taxed at a lower tax bracket. However, in reality, this is not always the case – some retirees find themselves in the same or higher tax bracket during retirement than they did during their working years by the time they consider all sources of income.
- When the account holder passes away, the RRSP’s will transfer one-time to a surviving spouse (if applicable) who can then access the investment as the new owner. Upon the death of the second spouse, the entire amount left in their RRSP portfolio is deemed to have been liquidated or withdrawn during the year of their death. This means that the full amount is then added to their income for the year, and therefore is subject to further taxation prior to the estate being fully settled. Unfortunately, if a financial plan is not structured properly, up to 50% of the funds could be handed over to the government in the form of taxes and fees.
For some people, it might make sense to purchase an RRSP loan. This strategy can help maximize the tax deduction for those in a high income tax bracket or catch-up on unused contribution room. Lenders offering the RRSP loans can typically amortize the loan over up to a 10-year period. However, in most situations the best way to make the loan work for instead of against you is to choose an amount that can be paid back within 12 months. This lowers the chances of creating a constant cycle of debt, as most people do not want to be paying for their 2013 RRSP’s in 2016! In addition, applying the tax refund immediately once it’s received towards the outstanding loan balance should be done to help keep things manageable.
It is worth nothing that regardless of where the RRSP is invested and even if a RRSP loan isn’t purchased, once the tax refund is received it ideally should be re-invested or used to pay down debt instead of spent on the newest toy or gadget, or annual vacation. This will help maximize the growth potential, and play a role in achieving greater financial success. Today and especially in the Vancouver area, fewer people have company-held pensions, therefore, investing and reinvesting your income tax returns in your RRSP’s can be a great avenue to grow your wealth to enjoy your retirement or later years.
What about TFSA’s?
While RRSP’s are a wonderful vehicle for many Canadians, for others they are not necessarily the best option. An alternate or complimentary investment strategy consideration for many Canadians is the Tax Free Savings Account (TFSA). TFSA’s are simply another investment vehicle, but the taxation rules are different. Interestingly, many people are surprised to learn that despite having the words “savings account” in its title, their TFSA can hold the exact same investments that their RRSP can, such as GIC’s, mutual funds, or stocks, amongst other choices. TFSA’s can be a phenomenal tax shelter, when used properly and invested wisely. Here are the basics that everyone needs to know:
TFSA’s basic tax and withdrawal rules are:
- As of 2014, the maximum available contribution room in the TFSA’s for Canadians over the age of majority is $31,000. The funds are invested after-tax, and no income tax deduction is given. In the same example given above with RRSP’s, someone who earns $50,000 annually and invests $5,000 into their TFSA will pay income tax on the full $50,000.
- Any growth that may be accumulated within the TFSA is tax-free.
- Since the tax was paid up front, when it comes time to withdraw the funds it is done tax-free. There is no tax payable!
- Upon death of the account holder, the proceeds of the account are given to a named beneficiary without any tax implications.
Canadians in the lower tax brackets may find a TFSA makes more sense over investing through an RRSP as they are perhaps not as concerned with receiving tax deductions. For others, a combination strategy could provide a better long-term outcome. Please speak to a financial professional to determine what investment vehicles and strategies will make your money work as hard for you, as you do for it.
Please don’t hesitate to contact me if you have any questions about RRSP’s or TFSA’s and what might make the most sense for you, or if you’d like a complimentary no-obligation review of your current portfolio.
To your financial success,
Financial Coach & Educator
phone: 604.888.4934 or 604.220.5719