Tim Cestnick is president of WaterStreet Family Offices, and author of several tax and personal finance books. tcestnick@waterstreet.ca
My grandfather once told me that 75 is a great age – when you're 80. The truth is, my grandfather enjoyed his senior years. He used to say "the older you get, the better you get. Unless you're a banana." Grandpa was good with his money and always thought of ways to beat the taxman. In the year he turned 71, his registered retirement savings plan matured and he took advantage of a strategy I want to share with you today. I call it the "seniors' overcontribution."
The scenario
Many seniors, like my grandfather, don't completely retire at a particular age. Seniors have much to contribute, and many prefer to work even part-time to keep active and supplement other income they may have. If you're in this boat and you expect to have earned income at age 71 or later, the idea I'm going to share can work for you.
So, here's the deal: Your RRSP can be a great vehicle to save for retirement, but you can't keep your plan around forever. You can have an RRSP until the end of the year in which you reach age 71, but then your plan matures and you'll need to wind up your RRSP by the end of that year. Most people convert their RRSP to a registered retirement income fund (RRIF), but that's a story for another day.
Many seniors would like to have the opportunity to claim RRSP deductions even after age 71 when their RRSP is no longer around. You can do this by contributing to a spousal RRSP if your spouse has not yet reached at 71 and still has an RRSP. Or, you can consider a "senior's overcontribution."
The strategy
You can gain the benefit of RRSP deductions even after the year you turn 71 if you make excess contributions to your RRSP before you wind-up your plan at the end of the year in which you reach 71. Now, you should be aware that a penalty will apply for the overcontribution, but the tax savings from the RRSP deduction will far outweigh that penalty. Consider Jack's example.
Jack turned 71 earlier this year, and so he has to wind up his RRSP by the end of December. Now, Jack has earned income this year of $134,833. This will provide Jack with RRSP contribution room next year of $24,270 ($134,833 x 18 per cent) – the maximum in RRSP contribution room possible for 2014. (Earned income in one year provides RRSP contribution room in the following year, at the rate of 18 per cent of your earned income).
The problem? Although Jack will have $24,270 of RRSP contribution room in 2014, he won't have an RRSP in 2014 since he's required to wind up his plan by the end of 2013. Does Jack lose the ability to make a contribution for 2014 and claim an RRSP deduction in that year? No. Jack is going to make his 2014 RRSP contribution in December, 2013, prior to winding up his RRSP.
Provided that Jack has already maximized his RRSP contributions for 2013, making an additional contribution of $24,270 in December will result in an overcontribution to his RRSP, and will result in a penalty of $223 for that month. Taxpayers are allowed a $2,000 overcontribution without penalty, so Jack will face a penalty on an overcontribution of $22,270 ($24,270 minus $2,000). The penalty is 1 per cent a month, so the penalty for December would be $223 ($22,270 x 1 per cent).
The good news? On Jan. 1, 2014, Jack's overcontribution problem disappears because he will be entitled to $24,270 of RRSP contribution room on that day thanks to his earned income in 2013. So, the overcontribution made by Jack will provide him with a $24,270 RRSP deduction in 2014, which will save him $11,264 in income taxes in 2014 since he's in the highest marginal tax bracket in Ontario. Jack is glad to pay the $223 penalty to save $11,264 in taxes.
The nuances
Be aware that Jack will have to file Form T1-OVP to report his overcontribution penalty to the Canada Revenue Agency. The form should be filed and the penalty paid 90 days after the end of the year. Failure to file this form can result in additional penalties.
Finally, in my example, Jack made an overcontribution for 2014 only. It may be possible, if he expects to have earned income beyond 2014, to make an overcontribution for future years as well. He'd pay more in penalties, but the tax savings could make it worthwhile, but do the math first.
Tim Cestnick