Now that this year’s deadline for making contributions to registered retirement savings plans (RRSP) has passed, many Canadians who managed to make contributions are looking forward to a tax refund in the spring. However, tax experts are quick to point out the advantages of having a long-term plan that keeps more of those tax dollars invested.
In fact, over a lifetime, investors can generate hundreds of thousands of dollars in extra retirement savings through “tax-free compounding.” The strategy allows tax savings to generate further tax savings while compounding in investments over time. It also means reinvesting that cherished RRSP refund that comes in the spring.
“It’s tough to try to get people to think about their long-term future selves rather than what’s going to happen in the next weeks or months,” says Doug Carroll, tax and estate specialist at Aviso Wealth Inc. in Toronto.
There are a few tax tools available to most Canadians that can be used together to maximize tax savings, which include an RRSP, a tax-free savings account (TFSA) and tax perks from investing in a non-registered account, he says.
The RRSP is traditionally the go-to investment vehicle for Canadians because contributions can be deducted from their taxable income. For example, if an investor’s marginal tax rate is 40 per cent, then that person’s tax refund will usually be 40 per cent of the contribution. Although that tax refund in the spring might seem like cash-in-hand, it’s merely the excess amount investors have had deducted from their paycheques over the course of the year on behalf of the Canada Revenue Agency.
For financial advisors, it’s important to remind clients that not only are there limits on RRSP contributions, but even keeping contributions well below those limits can be problematic as investments grow over time. That’s because if RRSP savings grow too much, the holder will eventually be forced to make withdrawals at a higher marginal tax rate and could lose out on government benefits such as Old Age Security.
“[Investors] may very well get to a point at which they have a sufficient amount in their RRSPs and as they project out in time, their income will be pushing up to a level that they will be facing clawbacks when they draw down on those assets,” Mr. Carroll says.
To maximize tax savings and avoid accumulating too much in an RRSP, he says advisors should recommend to clients that they contribute only when their annual income reaches a high tax bracket. In contrast, he says clients should channel other investment dollars into a TFSA when income and RRSP tax savings are smaller. (It’s worth reminding investors that while TFSA contributions cannot be deducted from income, withdrawals are never taxed.)
“[At an] early age, investors should lean toward a TFSA versus an RRSP and carry their RRSP contribution room forward. As they hit their stride in their working years and start going up into higher tax brackets, they can actually draw money out of their TFSA and contribute it to their RRSP,” he says.
In some cases, though, the overall tax advantage can be greater by holding some assets outside of both vehicles and in a non-registered account.
The biggest tax advantage in most non-registered trading accounts is the 50 per cent capital gains exemption, in which only half of the gains on stocks or other equity investments are taxed when sold.
The capital gains tax on TFSA holdings is zero, but Denise Batac, tax partner at Crowe Soberman LLP in Toronto, says investors who have contributed the maximum amount to their TFSAs should direct eligible equity investments and investments not permitted in registered accounts to their non-registered accounts.
“If investors have tax-efficient investments, they should probably hold those [in a non-registered account]. If they have non-tax-efficient investments – meaning those that are earning more income – they should probably be held in their RRSP or TFSA,” she says.
Dividend tax credits are also available on eligible equities only in non-registered accounts, but one often overlooked tax perk is the ability to benefit from market losses through “tax-loss selling,” Ms. Batac says. That allows investors to use half of the equity losses to recoup capital gains taxes paid going back three years or apply them against future capital gains.
“If investors are realizing losses, they can use those losses against any other capital gains incurred,” she says. “We are not able to use those losses [in an RRSP or TFSA] because nothing is being taxed at the end of the day.”
Ms. Batac says another often-overlooked tax advantage is income splitting between spouses. High-income spouses can split up to half of their income with a lower-income spouse once they turn 65, but the higher-income spouse can keep their RRSP contributions low and still deduct them from their income beforehand by contributing to a spousal RRSP.
“[An investor] makes a contribution based on their RRSP contribution limit. It goes into a spousal RRSP and, eventually, when they retire, it’s withdrawn and taxed in the hands of the lower-income spouse versus the higher-income spouse,” she says.
There are many misunderstandings about spousal RRSPs, Ms. Batac adds. Some people mistakenly contribute directly to the RRSP of the lower-income spouse without setting up a separate spousal RRSP, or they often don’t realize the contribution to a spousal RRSP reduces the higher-income contributor’s limit instead of the lower-income spouse’s.
She cautions that investors who get in over their heads on any tax matter could regret not getting help from a professional.
“They’ve now incurred penalties, have to go through and file all the respective forms, and when it’s all added up, they’ve probably negated a lot of the benefits that they would’ve otherwise realized from doing tax-planning strategies,” she says.