Editor's note: This week on Morningstar.ca, we present our Focus on RRSPs, where we go over what every investor needs to know about Canada's most popular savings program. Along with an explanation of RRSP basics, we will look at important issues such as whether it makes sense to defer savings, the life-cycle approach to retirement contributions, and ways to go beyond the traditional RRSP. Finally, our manager research analysts will present their favourite funds to hold in a retirement account. Check back all week for more insights from Morningstar's experts.
Having enough money during retirement is a worry for many Canadians, an ominous fact that surfaces every year at this time when banks and other interested parties conduct surveys on the subject. We're not putting away enough, we are warned, and the best way to save for our golden years is the RRSP. What's more, they remind us, the March 1 deadline for contributing to a registered retirement savings plan for the 2016 taxation year is drawing near.
These same institutions aggressively advertise a plethora of RRSP products at this time of year, behooving us to make important investment decisions before the annual deadline. In fact, the RRSP is a tax-savings umbrella under which you can hold investments ranging from cash to mutual funds to individual securities -- and even your home mortgage. And while the deadline is important in terms of the sum contributed being deductible on your 2016 tax return, if you can't afford to make the maximum contribution for the year by the end of this month you can "bank" the contribution room for future use.
The RRSP is a tax-deferral arrangement by which you put money into your plan, deduct that amount from your 2016 income (hence the deferral), and have your savings grow tax-free until you make a withdrawal, at which point the entire withdrawn amount (capital and income) is taxable. In the meantime, the money within grows at a faster rate, free of ongoing taxation. For 60 years, the RRSP has been Canadians' primary method of retirement saving.
Contribution limit for 2016
There are three components used to determine the maximum amount you are allowed to contribute to your RRSP each year. This amount is in addition to any unused contribution room you have from previous years.
- Your annual contribution is limited by your income level. It cannot exceed 18% of your previous year's earned income (for 2016 contribution purposes, your income during 2015). Earned income is basically your employment or net business income, as well as taxable child or spousal support, net rental income from real estate, Canada/Quebec Pension Plan disability pension, net research grants and royalties. The total from these income sources is then reduced by any tax-deductible child or spousal-support payments made by you, employment expenses, and losses from business activities and rental properties.
- Regardless of your income level, your contribution cannot exceed $25,370 for the 2016 taxation year. (For 2017, you will be able to contribute up to $26,010. The dollar limits are increased each year, based on inflation.) Basically, your earned income must be higher than about $141,000 to be able to make the full $25,370 contribution for 2016.
- If you are a member of an employer pension plan, your annual contribution is further limited by the deemed value of the pension-plan benefit you accumulated during the previous year (2015). This is known as your pension adjustment, and you can find this amount on your 2015 T4 employment-income slip and on the notice of assessment received after you filed your 2015 tax return. If you are a member of a group RRSP or other money-purchase (defined contribution) pension plan, the pension adjustment is basically the total contributions made during the year by both you and your employer. The calculation is more complicated for members of defined-benefit plans.
Unused contributions from past years
As mentioned above, the amount you can contribute will be greater if you have not made maximum RRSP contributions in previous years. For example, if you contributed only $8,000 a year for 2015 and your personal limit for the year was $12,000, that unused $4,000 contribution is carried forward to 2016 or future years. The same goes for unused contributions in previous years, and you can carry forward unused contributions indefinitely until the year in which you turn 71, when an RRSP must be converted to a registered retirement income fund (RRIF), a registered annuity, or cashed out.
If you are in a company pension plan and left that employer before the plan's stated retirement age, you may be entitled to a pension-adjustment reversal (PAR), which can be added to your RRSP contribution room.
Your 2015 notice of assessment provides your RRSP contribution room, but if you have any doubts about this amount -- particularly if it seems too high -- double-check it against your own records. You will be denied a deduction for any amounts contributed that ultimately are deemed to exceed your current limit.
What happens to overcontributions
If you overcontribute to your RRSP, the excess amount will be disallowed as a deduction. This amount would also be fully taxed once withdrawn from the plan; in other words, it would face double taxation. In addition, you'd face a penalty of 1% for each month in which you are in an overcontribution position. However, you ultimately would be able to deduct any excess amount in subsequent years, providing you generate new contribution room. You may be able to escape the penalty and taxation on the overcontributions if you act quickly and file the appropriate form with the tax authorities.
There is a safety net that provides limited protection from the 1%-a-month over-contribution penalty, though. You are permitted to maintain an excess contribution of up to $2,000 at any given time, and not be penalized. In some cases, it may be advantageous to maintain a $2,000 overcontribution balance. The amount isn't tax-deductible and thus would face double taxation, but the long-term benefit of investment compounding might more than offset the taxes paid.
Many types of investments can be held within an RRSP. The simplest are cash accounts, term deposits and guaranteed investment certificates (GICs) at a bank, credit union or trust company. You can also purchase a mutual fund at one of these institutions or, in some cases, directly from a fund company. To invest in stocks, dealer-sold mutual funds, exchange-traded funds, bonds and other individual securities, you must set up a self-directed RRSP with one of those institutions or an investment dealer.
If it isn't practical to make an investment decision before the March 1 deadline, you can simply make a 2016 contribution in the form of an RRSP-eligible cash or short-term deposit before the deadline, and then decide afterward where to invest it for long-term growth.
