While the RRSP is a great vehicle to help Canadians save for their retirement, there are some pitfalls that investors may not know about and should try and avoid.
Many people, for example, confuse their contribution limit with the deduction limit.
The deduction limit is set at 18 per cent of your previous year’s earned income, up to a dollar limit, which changes every year. The maximum dollar limit for the 2012 tax year is $22,970, up from $22,450 in 2011, and will rise to $23,820 in 2013. It is contained in the Notice of Assessment that you get each year from the Canada Revenue Agency after you have filed your return.
If you have not been contributing the full amount to your RRSP and have unused contribution room, your contribution limit could be higher than the deduction limit. If, for example, you have $20,000 of unused contribution room from previous years, your actual contribution limit for 2013 could be $43,820 – your 2013 deduction limit plus your past unused contribution room.
Another pitfall can be saving too much in your RRSP and having too many accounts.
An RRSP of between $700,000 and $2-million, for example, may sound great, but that money will be taxed at some point. A retiree with such a large plan would be in the 46 per cent tax bracket and would have their Old Age Security (OAS) clawed back.
Having your financial assets spread over several plans can lead to a disorganized investment strategy, duplication, inappropriate asset allocation and paying more fees than if all investments were consolidated in one account.
Waiting to the last minute to make your contribution is another common pitfall. It can lead to making emotional decisions or parking the money for too long on the sidelines. By contributing early or making regular contributions during the year you get the tax-sheltered returns starting sooner and get the advantages of dollar cost averaging.
Many people may not realize they have a choice when they can actually claim their RRSP contribution. You don’t have to do it in the same year that you actually make the contribution.
“If your income is below $45,000 one year but you expect it will go up the next year, you can make the contribution but then wait until the second year to actually claim it,” explains Myron Knodel, director of tax and estate planning with Investors Group. “In this way you would get a greater tax break from your contribution because you are claiming it in a year when your income is higher.”
Many people may also be investing in the wrong things in their RRSP.
The advantage of investing in registered accounts such as RRSPs and Registered Retirement Income Funds (RRIFs) is that the money is only taxed when the funds are withdrawn. When you take money out of your RRSP at 71, you are taxed at your marginal rate at the time, which is usually lower than when you were working full-time. As a general rule, it’s better to invest in fixed income in your RRSP and equities outside of your RRSP in a non-registered account.
You can claim a capital loss from equities if they are in a non-registered account whereas you can’t if they are in a registered plan. And capital gains made on equities held in a non-registered account are taxed at only 50 per cent of the individual’s marginal tax rate.
Consequently, non-registered accounts generally should contain equities and dividend paying stocks instead of interest-bearing investments such as Guaranteed Invest Certificates and bonds which should be in your RRSP.
Don’t withdraw your money from your RRSP early because it is taxed very heavily and try to take advantage of both your RRSP and the Tax-Free Savings Account (TFSA).
Although the TFSA was introduced five years ago, a recent BMO Bank of Montreal survey found that fewer than half of Canadians have been making the maximum contribution of $5,000 a year. The maximum contribution this year is going up to $5,500.
“Look at what your tax rate is now and what you expect it to be when you retire,” Knodel advises. “If you expect your marginal rate will go down when you retire it’s better to make contributions to your RRSP and take the tax refund and reinvest it. If you are not saving for retirement a TFSA is usually preferable to an RRSP because you can remove money from it tax-free but funds removed from your RRSP is taxed when removed.”