Planning for the Creeping Tax Liability in your RRSP

I am back. I needed a hiatus to deal with various administrative issues relating to the blog, including having the blog suddenly disappear into the ether for a couple days. I believe everything is now sorted out and I am ready to resume blogging.

In January, I wrote a post titled RRSPs and Corporations – Your Silent Creeping Tax Liability. The blog noted that whether you are currently working, near retirement or in retirement, you  have silent creeping tax liabilities accumulating in your Registered Retirement Savings Plan ("RRSP") and/or corporation.

I received very positive feedback on this post and several readers asked me to follow up with some potential planning to mitigate these “creeping” taxes. Today, I will do just that in relation to planning for the tax liability of RRSPs (also some planning not directly related to your RRSP tax liability). Later next month I will follow-up with some planning in respect of corporations “creeping” tax liability. While most of the potential planning considerations relate to those close to or in retirement, there are some considerations for you “young-ins”.

RRSPs

Spousal RRSPs

As a quick refresher, spousal RRSPs are contributions typically made by the higher income spouse (contributor) based on their RRSP contribution room (not their spouses), on behalf of their lower income spouse (known as the annuitant). A spousal RRSP made by the higher income spouse will generate the maximum tax refund to the family unit.

Conceptually, by utilizing a spousal RRSP, retirement funds effectively move from a spouse that will be highly taxed in retirement to a spouse that will be taxed at a lower rate in retirement.

It should be noted,that if the annuitant spouse withdraws funds from their spousal RRSP within at least 3 years of a contribution, there is an attribution rule that will require the withdrawal to be added to the contributing spouse’s income in the year of the withdrawal (i.e. – if you made a spousal RRSP contribution in January 2020, your spouse must wait until 2023 before they make a RRSP withdrawal, or else the withdrawal is taxed in your hands). This rule seems to confuse many people; the CRA provides a good example of how this rule works here.

With the introduction of pension income-splitting in 2007, which allows you to transfer up to 50% of your pension income (including RPP, RRSP, RRIF and annuity income amongst other income types) to your spouse or common-law partner, by completing form T1032, many people assume spousal RRSPs have gone the way of the Dodo bird. However, this is not entirely true.

For example, in pre-retirement years, it may be prudent for a low-income spouse to withdraw funds from their spousal RRSP (as long as they do not breach the 3-year rule noted above) if they expect their marginal tax rate in retirement to be higher. This provides maximum planning flexibility. In determining whether the marginal income tax rate savings are worthwhile, you will need to consider the time value of money and inflation versus the actual tax savings.

A further benefit of a spousal RRSP is that a lower income spouse will receive 100% of the funds from their spousal RRSP/RRIF and be eligible to split their spouses RRSP/RRIF. If you do not utilize a spousal RRSP, only 50% of the higher income spouse’s RRSP/RRIF could be split. The spousal RRSP thus provides the maximum income splitting flexibility in retirement.

Your RRSP

Similar to a spousal RRSP, it may be beneficial to withdraw funds from your own RRSP in a low income year (say a poor commission year). Or more likely, in the years between retirement and when you have to convert your RRSP to a RRIF (by December 31st of the year you turn 71) if your income is lower and you expect a higher marginal tax rate in retirement.

Prescribed Rate Loan

Where one spouse has significant non-registered assets and pays tax at a high or the highest marginal tax rate and the other spouse has a low marginal tax rate with minimal assets or taxable income, consideration should be given to a prescribed rate loan. See this blog post on the topic. The current prescribed rate is 1% until June 30th, but the rate will very likely increase in the third quarter.

While this tax planning technically has nothing to do with a RRSP, it may reduce the taxable income of the higher spouse such that some of their RRSP/RRIF income is taxed at a lower rate.

Pension Credit

If you are between the ages of 65 and 71 with no pension income, you may wish to consider converting a portion of your RRSP into a RRIF and drawing $2,000 per year from the RRIF. This will allow you to claim the $2,000 pension income tax credit. If you do this, you may want to just transfer $14,000 at the outset and take $2,000 per year from age 65-71.

Old Age Security

To the extent you may draw your RRSP down in your early 60’s or take the minimum RRIF amount in your early 70’s, always ensure your planning considers the OAS clawback. The clawback for 2021 starts at $79,845 of net income ($81,761 for 2022). Once the $79,845 limit is exceeded, you will have to repay 15% of the excess over this amount, to a maximum of the total amount of OAS received which is reached at $129,581 of net income.

Tax Efficient Investing

I wrote on this topic in 2017, here are the links to my two blog posts, Part One and Part Two. These posts discuss which type of account (non-registered, registered, TFSA) is the most tax advantageous to hold investments and maximize returns. Investing efficiently may in some cases reduce your ultimate RRSP and thus your “creeping” tax liability, because you increase other more tax efficient sources of income than your RRSP.

Withdrawal Ordering Methodology

While the methodology of your retirement withdrawals will not directly affect your creeping RRSP tax liability, it is part and parcel of minimizing your overall tax burden in retirement.

Fixed Amounts  

You, your financial planner, or accountant can generally project what income sources will be included in your income each year in retirement. Those will include CPP, OAS and the minimum RRIF withdrawal amounts and non-registered account interest and dividends and possibly rental income etc. There may be other amounts, but these are the standard income sources. From these amounts you can determine an initial projected pension splitting amount. Once you do this, you will know how much income you will have to cover your yearly cash withdrawal requirements and what your marginal tax rate will be approximately. You then need to plan the most tax effective way to cover any retirement cash shortfalls with other accounts such as non-registered accounts, excess RRIF withdrawals and TFSAs in the most tax effective manner.

Ordering

So, what is the best ordering methodology? Depends on whom you ask.

Some people suggest that the best way to make withdrawals in pre-retirement and retirement is to take money from the least flexible and least tax efficient source first. This methodology would typically result in you first drawing from your RRSP/RRIF, then your non-registered account and then your TFSA. A somewhat similar suggestion is that you take money from accounts with the highest tax liability at the lowest possible marginal tax rate. Others suggest you keep your RRSP intact and defer the tax as long as possible. Then there are other financial experts who suggest you keep your TFSA intact to provide the utmost in tax-free withdrawal flexibility. Finally, in a recent Globe and Mail article by Frederick Vettese (it is behind a firewall for Globe subscribers only), he suggested it may be best to drawdown from multiple sources rather than trying to keep your RRSP intact (to defer tax) as long as possible.

What these various opinions prove, is that there is not a one size fits all methodology and each person needs to review their circumstances and run various scenarios (with your financial planner or accountant if you have one) to find what is the correct methodology for you.

Looking out at the Grim Reaper – Taxes on Death

The above planning may need to be tweaked when you consider the taxes due on your death. Typically, when the last spouse dies and the balance of their RRIF and the deemed gains on their investments are taxed, it leaves their estate in the highest marginal rate or at a much higher rate than prior to their passing. 

Tim Cestnick in another Globe and Mail article (again behind a firewall) suggests it may be more advantageous to bring in more RRIF income (and contribute the excess RRIF income less taxes to your TFSA) over many years at a lower rate, than to defer the tax on your RRIF to your death at the highest or higher marginal rate. Again, you need to review your own particular circumstances (the time value of money will require the tax savings to be large enough to make this worthwhile), but this is something that should be considered.

Much of the planning I discuss above unfortunately requires significant number crunching to achieve the optimal results. This planning can be complicated and requires a huge time commitment. I suggest engaging a financial planner or your accountant to prepare a plan for your retirement, it will be typically money well spent.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

Exploding 19 Common RRSP Myths

It’s that time of year again. We have just a few weeks left until the Registered Retirement Savings Plan (RRSP) deadline, and despite its almost 60 years in existence, there are still plenty of myths and misconceptions surrounding this popular retirement savings plan.

Today, Sarah Rahme, CFP, a wealth advisor with BDO Canada LLP, gets us ready for the 2019 RRSP deadline by demystifying 19 common RRSP myths.
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Myth #1: RRSPs are for everyone

The reality is that every Canadian needs to evaluate their own fit for an RRSP. We generally say that Canadians earning a lower income (under $50,000 yearly) should use a Tax Free Savings Account (TFSA) instead. Moderate earners have to weigh the pros and cons before deciding which option will work better for them in the long run. This typically entails weighing the tax savings you would gain today versus the tax cost when you withdraw your RRSP or Registered Retirement Income Fund (RRIF) in the future and how quickly you may need to access the funds in your TFSA.

Myth #2: RRSPs aren’t worth it, since you need to pay tax on withdrawals

Some of you may wonder: what is the point of sheltering tax now since you will be paying it back at some point? Needless to say, should your tax bracket be lower in retirement, you will benefit from significant tax savings and tax-free compounded returns.

But what if your tax rate ends up being higher during retirement? We believe depending upon your specific situation, you may still be ahead based on the long-term tax-free compounding effect.

Myth #3: RRSPs have one use — retirement

An RRSP can also be used for two other key purposes:

• purchase your first property through the Home Buyer's Plan (HBP) (up to $25,000 to purchase your first home)
• finance your or your spouse’s training or education with the Lifelong Learning Plan (LLP) ($10,000 per year up to $20,000 in total to finance your education at a qualifying institution).

Myth #4: I should pay off my mortgage and other debt first

Let’s distinguish between two types of debt: high-interest and low-interest. For high-interest debt – the best example is credit cards, which can carry rates of up to 29.99% – absolutely, paying off debt should take precedence. But when it comes to low-interest debt, such as a mortgage, be careful not to scrimp on retirement savings. As long as you can generate a return on your investments that is higher than your cost of borrowing, it may make more sense to invest rather than pay down that low-interest debt.

Myth #5: I cannot make a withdrawal from my RRSP until I retire

Technically, funds in an RRSP are available to the plan holder at any time, even if there is a withholding tax on the funds withdrawn. (The exception, of course, is withdrawals under the Home Buyer's Plan or Lifelong Learning Plan, which are tax-free.) That being said, unless you really need the money, try to withdraw RRSP money at a time when your tax bracket is the same or lower than it was at the time of the contribution. Be aware that the statutory tax withholding may be significantly less than the actual income tax you owe in April, so plan for this shortfall.

Myth #6: It doesn’t matter when I make my spousal RRSP contribution

This may be the case if you don’t intend to make a withdrawal from the plan in the next three years, but if you do, the contribution timing matters.

As a reminder, spousal RRSPs allow one spouse to contribute to the other’s RRSP. This can often be a sound tax strategy when one spouse earns significantly more money than the other. However, spousal RRSPs come with conditions. One big one is that funds withdrawn within three years are attributed as income to the contributor and taxed accordingly.

Withdrawal rules are based on calendar years, which means that if you make a contribution for 2019 by December 2019, you’ll be able to withdraw money attributed to the plan holder as soon as January 2022. If you make that same contribution sometime in the first 60 days of 2020, you’ll have to wait until January 2023 before withdrawals are taxed in the plan holder’s hands.

Myth #7: I’ll have more money to contribute when I’m older

This is not always the case. It’s true that your student loans will be paid off, and you’ll most likely generate more income. But you may also have new obligations, such as a mortgage or the financial responsibilities of child-rearing.

Myth #8: If I die, the proceeds of my RRSP are subject to taxation

Not always – there are two scenarios:

• If the beneficiary of the deceased is a surviving spouse or common-law partner, the funds will roll over tax-free into their RRSP or RRIF.
• If you have a child or grandchild who was dependent on you due to physical or mental infirmity, the funds will roll over tax-free into their RRSP or RRIF.

Myth #9: I don’t have enough money to start investing

Like with all investing, the secret formula is compounding. If you begin your investment journey, even with small sums, a long-term strategy will build those initial amounts into greater wealth.

Myth #10: I have to take my deduction in the year I contribute

Well, you can definitely claim your RRSP deduction every year – and benefit from the tax deduction immediately. But remember: If you think your tax bracket will be higher in subsequent years, you may want keep the deduction in your back pocket and maximize your tax savings.

Myth #11: I can only convert my RRSP to a RRIF when I turn 71

It is true that you must convert your holdings by the end of the year in which you turn 71. You can, however, convert a portion, or the entire amount, at any earlier age. In fact, it may make sense to withdraw $2,000 per year from your RRSP to utilize your pension tax credit to offset the taxes on the RRIF income once you turn 65.

Myth #12: Converting my RRSP to a RRIF is my only option when I turn 71

You also have two other options:

• take out the account value as a lump sum cash payment. In this case, you’d need to pay tax on the whole payment.
• buy a life annuity that would pay income at regular intervals for the rest of your life.

Myth #13: A Spousal RRSP doubles my contributing room

Your personal RRSP contribution limit doesn’t change just because you have two accounts at your disposal. You have a choice to use your own RRSP, your spousal RRSP or a combination of both, but only up to your personal RRSP limit.

Myth #14: I have to use cash to make my RRSP contribution

RRSP contribution rules offer you more ways to contribute than just cash. You can also use stocks and bonds and make what is known as a contribution-in-kind. However, if you transfer stocks or bonds with an unrealized gain, you will trigger a capital gain, and if the stocks or bonds are in a loss position, your capital loss will be denied.

Myth #15: I should borrow money to contribute

Sure, that’s an option. But it’s probably better to make contributions to your RRSP throughout the year. Many people do this via a regular payroll deduction. This both helps your long-term savings and decreases your debt obligations.

Myth #16: I should contribute a lump sum just before the Feb. 28 deadline

Many Canadians do follow that strategy, but it’s suboptimal. First of all, you lose out on a year of tax-free growth for your funds. Besides that, are you convinced you’ll have access to the necessary funds in the waning days of February?

Myth #17: I have to wait until I turn 18 to open an RRSP

This is a common source of confusion. In reality, an RRSP can be opened at any age. A TFSA, on the other hand, can only be opened by someone 18 years or older. That being said, typically it will not make income tax sense to contribute before you are earning substantial income.

Myth #18: I can hold any types of investments in my RRSP

The RRSP rules do restrict some investment vehicles, such as precious metals and land. Some other vehicles are permitted but can be problematic and complex. These include mortgages and shares of a private corporation. Speak with your financial advisor to learn more about holding these vehicles in your RRSP.

Myth #19: My employer sponsored pension plan does not affect my RRSP contributions

Registered pension plans and deferred profit-sharing plans affect your RRSP contribution limit in the same way. Your annual T4 information slip from your employer includes a pension adjustment amount which reduces your RRSP contribution room.

The general formula is as follows: Your RRSP deduction limit for a tax year starts with contribution room carried forward plus your current year’s contribution room, minus any Pension Adjustment or Past Service Pension Adjustment and plus any Pension Adjustment Reversal.

Sarah Rahme, CFP, is a wealth advisor with BDO Canada LLP and covers Eastern Canada. If you would like help structuring a customized comprehensive financial plan for you and your family, contact Sarah at SRahme@bdo.ca or 613 739-8221, ext. 4520. For other parts of Canada, contact Sarah and she will direct you to the BDO contact person in your region.

The content on this blog has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The blog cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information on this blog or for any decision based on it.

Please note the blog posts are time sensitive and subject to changes in legislation.

BDO Canada LLP, a Canadian limited liability partnership, is a member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms. BDO is the brand name for the BDO network and for each of the BDO Member Firms. 

Common Personal Income Tax Errors

In today’s blog, I will discuss some of the more common personal income tax planning and personal income tax tracking errors I observe as a tax chartered accountant. Most of these planning and tracking errors are very subtle in nature. Many taxpayers utilize income tax software programs to prepare their personal income tax returns; I would suggest that these programs would not necessarily bring these matters to your attention, as the issues are not input based.

The following are common errors I observe on a consistent basis:

Transfer of investments with unrealized losses to a RRSP

Where you transfer an investment with an unrealized loss to your RRSP as a RRSP contribution, the capital loss on the disposition to your RRSP is disallowed. For example, if you bought shares of Research in Motion for $50 and transferred it from your non-registered trading account to your RRSP when the value was $35, the $15 capital loss would be denied. I have seen taxpayers claim this capital loss when they are not entitled to do so. Thus, you should be extremely careful to ensure you do not transfer any investments with an unrealized capital loss to your RRSP.

Spousal RRSP

A spousal RRSP counts as a contribution by the contributor. If Jennifer has a RRSP contribution limit of $18,000 and contributes $18,000 to her husband Tom’s RRSP, she receives the $18,000 income tax deduction and cannot contribute to her own RRSP. If Jennifer contributed $12,000 to Tom’s RRSP, she can only contribute up to $6,000 to her RRSP. The combined total cannot exceed her $18,000 RRSP limit. However, I often see people misinterpret these rules and make total contributions that exceed their RRSP contribution limit.

T3 income tax slips

These tax slips may contain an amount indicated in Box 42. This box relates to the return of capital on income trusts and similar investments. The amount in Box 42 indicates the amount of tax-free distributions received during the year and must reduce the adjusted cost base of the related investment. Many people do not keep track of their reduced adjusted cost bases. For example, if you purchased an income trust or similar investment for $14 in 2010 and the amount in Box 42 in the 2010 T3 slip is $1.50, the new adjusted cost base of that investment would now $12.50. If you were to sell the investment in 2011 for $15, the capital gain would be $2.50, not $1.

Depreciation on rental properties

A very subtle but significant error is in connection with rental properties. Many people purchase rental properties with friends or relatives and do not give any consideration to signing a partnership or joint venture agreement in regards to the property. This is a complicated legal issue, however, for income tax purposes, if the property is a partnership, the capital cost allowance [(“CCA”), known to many as depreciation for tax purposes] must be claimed at the partnership level and thus, the partners share in the CCA claim. However, if the property was purchased as a joint venture, each venturer can claim their own CCA, regardless of what the other person has done. (I will discuss this issue in greater depth in an upcoming blog on the income tax implications of owning a rental property).

Joint bank accounts

Many spouses arbitrarily open bank and investment accounts in the names of both spouses even though only one spouse may have earned and contributed all or the majority of the funds. This may lead to incorrect tax reporting results. For personal income tax purposes, technically, the spouse who earned and contributed the money to the account originally should report 100% of the interest, dividends or capital gains that are earned in that account on the original amount (there is no attribution back to the contributing spouse on the income earned on the income (i.e. “secondary” income). This is not necessarily what I see happening in reality.

Car expenses and home office related to employment

Many employees require their cars for work or are required to maintain a home office. Should you fall into either of these categories, you should ensure you get your employer to sign Form T2200, which will enable you to deduct these costs as employment expenses. Often, when I ask whether a taxpayer if they have obtained the Form T2200, they answer no.

Interest expense

Many people use their line of credit to borrow to make investments. The interest on these monies is typically deductible for income tax purposes. However, many people also use their line of credit for personal expenses, thus, mixing non-deductible personal interest expense with deductible investment interest expense. Where this is the case, you should track the amount the principal amount of the line of credit used for the investments on an excel spreadsheet for back-up in case of an audit by CRA. For example, if you took out $15,000 on your line of credit to make an investment, and the total line of credit balance is $100,000, you should allocate 15% of that month’s interest to your deductible interest expense. Any repayments to the line of credit must be prorated between the personal and non-personal amounts outstanding and cannot be allocated in whole to one or the other. Taxpayers often believe that they can apply the full repayment to the personal portion of their line of credit and therefore can claim a higher interest expense deduction for personal tax purposes.

1994 capital gains election

In 1994, the $100,000 capital gains exemption was phased out. However, individuals were eligible to make an election on their 1994 personal tax return to bump the value of their capital properties by up to $100,000. Many people made this election on their cottages and stock investments and never informed their children. Where the parent ages and forgets about this election or in some cases passes away, the children may not be aware of this election and the estate can pay more income tax than is necessary.

Tax planning does not always mean NO tax

The errors noted above are actual physical income tax planning errors. However, the biggest error committed by many people, is more mental than physical; when they attempt to reduce their income tax bill at any cost. As discussed in my blog The Income Tax Planning dog, wagging the Tax Dodge, this philosophy can often be at a significant personal detriment. 

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.