Tax

ASK RK: Should I borrow money for an RRSP contribution? 

Borrow money to make money. It’s an old strategy and a good strategy, as long as it’s employed wisely. Here’s what you need to know about leverage and your RRSP contributions
RRSP-contributions

As the RRSP deadline quickly approaches, many Canadians are scrambling to find the money to make a contribution to this tax-deferred account. Some of those Canadians are wondering whether or not to borrow money for that RRSP contribution, while others if they should forego the loan, and the hassle, and skip this year’s contribution altogether? 

Unfortunately, the answer isn’t a one-size-fits-all solution when it comes to borrowing money for RRSP contributions. 

Fortunately, there are some general guidelines and principles that can help you make the right decision for your situation. 

QUICK FACTS: 

      • Deadline for contributions for 2019 tax year is March 2, 2020

      • If you contribute money into your RRSP within the first 60 days of 2020 you must report it on your 2019 taxes, even if you don’t plan on carrying that contribution amount into next year’s tax return.

      • All retirement funds count towards your RRSP contribution limit — this includes employer pooled pension funds, share purchase plans and contributions to spousal RRSPs. 

      • Deadline to submit your 2019 tax return, and taxes owed, is midnight April 30, 2020

      • Self-employed people and their spouses have until June 15, 2020 to file their return, but the clock starts at 12:01 am May 1, 2020 for penalties and interest on taxes owed for 2019. 

The answer boils down to whether or not your contribution to a Registered Retirement Savings Plan (RRSP) will benefit you now and in the future. 

If it does, then the quick answer to this question is: yes. 

But to make a smart decision, it’s best to dive into the weeds a bit. 

(If you already know you need to borrow in order to contribute to your RRSP, then jump to our quick calculation method to find out how much to borrow). 

What you’ll learn: 

Benefits of RRSP

The RRSP is a powerful tool for a few reasons: 

  • It defers the tax you pay on earned income until a future year, allowing you to withdraw and pay tax on that money, during retirement, when you are theoretically earning less putting you in a lower tax bracket.
  • You get credit from the taxman on money contributed to an RRSP. The credit, known as a tax refund, is based on the assumption that you’ve paid tax on that money, but you are now electing to defer your tax payment to some future time, so you are owed that already paid tax money. 
  • Working with time and the power of compounding interest, the money you invest can grow quite substantially.  

In sum, any RRSP contributions you make are tax-deductible. That means you can claim these contributions as a tax deduction when you file your income tax return. This lowers the tax you pay, as it lowers your income (and, if you’re fortunate, could bump you down to a lower marginal tax bracket, further reducing the tax you pay).

Got a personal finance, tax or real estate question? Ask RK

How does an RRSP work?

When you contribute to your RRSP, the CRA deducts this amount from your income and, as a result, lowers the annual personal income tax you owe. The higher your income, the bigger the savings because your tax rate is higher

How do marginal tax brackets work?

But that doesn’t mean that every dollar you earn is taxed at that higher rate. 

It means that each dollar earned in a tax bracket is charged this tax. The more you make, the further you go up the income tax ladder until you get to the top tier. 

To illustrate, let’s assume you earn $98,000. This salary puts you in the 26% federal tax bracket (there are also provincial taxes). This doesn’t mean you’d pay $25,480 in taxes ($98,000 x 26%). Instead, each earning bracket is taxed, based on those rates. In other words, your tax would be calculated like this: 

  • Pay 15% on the first $48,535 of taxable income ($7,280.25), and
  • 20.5% on the taxable income over $48,535 and up to $97,069 ($9,949.68), and
  • 26% on the taxable income over $97,069 ($242.06)

Total tax bill using marginal tax brackets = $17,471.99

To sum it up: The marginal tax rate is the amount of tax paid on any dollar earned until you pass the minimum amount for the next tax bracket. 

How much you can contribute to your RRSP each year?

There are limits on how much you can contribute each year to your own RRSPs and, if you’re married or in a common-law relationship, to your partner’s RRSPs. 

Your maximum contribution each year is calculated based on a percentage of the earned income from the previous year, or the maximum contribution amount for that tax year minus any contributions to your pension. 

Put another way, your maximum RRSP contribution, for any given year, is the lower of:

  • 18% of your earned income from the previous year;
  • The maximum annual contribution limit for that taxation year (this is posted by the CRA and can be found online);
  • The remaining limit after any company-sponsored pension plan contribution or group RRSP contribution.

(Keep in mind your RRSP deduction limit is capped at 18% of your income or CRA’s capped maximum sum, but your RRSP contribution limit also includes any unused RRSP rooms from previous years.)

If you want to be precise about your maximum RRSP contribution for this tax year, go online to ‘My Account’ on the Canada Revenue Agency’s site

How does a pension impact RRSP contributions?

If you are fortunate enough to work with an employer that offers a pension, you need to take into consideration how yearly pension contributions will adjust your annual RRSP contribution limit. 

Since pension contributions work like registered retirement contributions — put into a fund that you do not access until retirement and if you do, there are withholding fees — you have to subtract your “pension adjustment” (PA) from your total RRSP deduction limit for the year

Thankfully, the CRA will include this information on your notice of assessment. Check the NOA you received from the CRA after filing last year’s tax return. It lists your deduction limit for the current tax year, as well as information about your PA. You can also find this information on your CRA My Account page. 

How do I handle an over-contribution to my RRSP?

Disciplined savers, those looking to aggressively take advantage of legitimate tax strategies, and both seasoned and naive investors may find themselves in a position where they contributed more than they are allowed to into their RRSP in a given year. 

Not to worry. Every Canadian is allowed to over-contribute $2,000 and not be penalized — but this ‘pass’ is only offered once in your lifetime. 

The contributions you make to all your registered retirement accounts will count towards your annual contribution limit, including employer or personally held pooled registered pension plans (PRPP), RRSP, share purchase plans (SPP) or your spouse or common-law’s RRSP or SPP. 

If you over-contribute more than $2,000 or you over-contribute more than once in your lifetime,  you’ll be charged a penalty of 1% on the over-contribution amount per month

If you realize you’ve made an overcontribution, immediately do the following:

  1. Pay the penalty.
  2. Withdraw the excess amount.
  3. Contribute to a qualifying group plan. 

For this last step, you’ll need to prove to the CRA that you either had RRSP contribution room that was unused in prior years — thus bumping up your contribution limit — or your income increased, thereby increasing your contribution room.  

At 1% per month, the penalty doesn’t sound like much until you realize that the amount is charged starting day one, even though you don’t learn about the overage until you receive your Notice of Assessment (NOA) — about two weeks after filing your taxes, if you did it electronically, or as long as two months if you filed a paper return. 

Now, if you made an honest mistake or you can show quick action to rectify the problem, ie: withdrawing the excess contribution, then you may be able to appeal the penalty. To do this, write a letter to the CRA. In the letter: 

  • Ask to cancel or waive the penalty charged for over-contribution on your RRSP.
  • Include copies of your RRSP, PRPP, SPP, or registered retirement income fund (RRIF). 
  • Show documentation as to when you withdrew the excess contributions. 
  • Any supporting paperwork that shows how your over-contribution was due to an error. 

But, wait. There’s more. 

Whether it was a mistake or not, the over-contribution will need to be removed. To do this, you need to fill out and file a T3012A. The CRA will confirm and certify the total over-contribution amount. Once certified, you can withdraw the excess money without paying the 30% withholding tax, that’s typically applied to all early RRSP withdrawals. Work fast, however, as the over-contribution penalty keeps growing until you withdraw the funds.

When should you contribute to an RRSP??

Anyone with a social insurance number and who has earned income and filed a tax return can contribute to an RRSP up until December 31 of the year they turn 71. After this age, if you continue to have earned income, you can contribute to a Spousal RRSP up until December 31 of the year your spouse turns 71.

The tax refund you get back is based on your marginal tax rate. For example, if you make $50,000 per year and live and work in B.C, you are in a 28.2% marginal tax rate (provincial plus federal rate). If you choose to contribute $1,000 to your RRSP, you will save $282 or 28.2%. 

The higher the tax bracket, the bigger the tax savings. The lower the tax bracket, the lower the tax savings. 

For that reason, you should contribute to an RRSP when you are in a high marginal tax rate (38% for example) and take it out when you are in a low marginal tax rate (22% for example). 

To calculate how much you’ll need to contribute to your RRSP in order to meet your retirement needs, consider using an online calculator. Just remember, however, that junk in is junk out. If you don’t have accurate information you won’t get an accurate contribution limit from the calculator. 

When should you not contribute to an RRSP?

It also means that it might not be a good idea to contribute money to your RRSP, for instance when you are in a low marginal tax rate (25%) or if you believe you’ll end up earning more in retirement (putting you in a higher tax bracket). 

Of course, this general principle gets complicated when you start to add in other factors. To help, here are four guidelines on when should you not contribute to an RRSP:

  1. If your annual income is too low.
    1. An RRSP contribution works as a tax deduction against your income. If your income is too low, you will not benefit from that tax deduction.
    2. Rule of thumb: If your income is below $50,000 (or the upper threshold of the second marginal tax bracket, putting it around $48,500) then you won’t see any significant tax benefits from an RRSP contribution. 
  2. If you anticipate an annual income in retirement that is higher than your current annual income then you will not benefit from an RRSP contribution.
    1. Entrepreneurs and business owners often fall into this category, as their annual earnings can be significantly lowered through current annual taxable deductions. 
    2. Rule of thumb: It’s best to calculate whether or not you anticipate higher earnings in retirement — say from the sale of your business, or from future sales commissions — making an RRSP contribution now, a poor choice. 
  3. If you have too much money in your RRSPs. 
    1. For those fortunate enough to save well or sell stock at the right time, your RRSP savings could grow significantly and it may force you to withdraw a larger sum each year in retirement, bumping you into higher tax brackets. If this looks like the case, investing more in an RRSP is not wise.  
    2. Rule of thumb: Do the math. Consider your marginal tax rate in retirement, as well as your annual withdrawal rate — a percentage of your savings that you’ll need to withdraw each year in order to live. Then calculate how much you’d need to withdraw to smooth out your tax rate in retirement. 
  4. If you expect your salary to grow in the near future. 
    1. This typically applies to newly graduated post-secondary workers, as well as apprentices in trade work fields. Remember, the deduction you earn from an RRSP contribution is equal to your marginal tax rate, so the higher your marginal tax rate, the higher your tax refund. 
    2. Rule of thumb: Consider your current annual earnings and then realistically consider future earnings. If you anticipate a bump up in pay in the near future, consider not contributing to your RRSP this year, carrying that contribution room forward, and making a contribution when your earnings are higher. 

Don’t want a loan and don’t have enough money to contribute to your RRSP, no problem

Not everyone likes to use leverage, even if it can help them build their savings. 

For those that prefer not to take on debt, don’t worry if you don’t have the money to contribute to your RRSP this year. 

The CRA allows you to carry forward your contribution room indefinitely to future years. This works in your benefit if you anticipate your earnings to rise in the future. 

To illustrate how the carry-forward works, let’s assume your contribution room was $15,000 in 2018, but your earnings were low and you decided not to make a contribution to your RRSPs. Then, in 2019, your earnings jumped and you can now contribute the maximum amount to your RRSPs, which is $25,600. At this point, you can make a total RRSP contribution of $41,500 ($15,000 + $26,500).

To find out precisely how much unused-contribution room you have, read your most recent most Notice of Assessment, or log into the CRA’s My Account and look for your RRSP Deduction Limit Statement.

Should I borrow money for an RRSP contribution? and how much?

It can make a lot of sense to borrow money in order to increase your annual RRSP contribution. The key is to minimize the costs and to plan how and when you’ll pay off this debt.

The best strategy is to only borrow an amount that is matched by the refund you’ll receive. That way you are paying little or no interest on the loan and you get the advantage of compounding interest on those savings.

Thankfully there is a fairly easy and quick formula for figuring out how much to borrow (based on your expected tax refund). Here are the steps to take

  1. Calculate your marginal tax rate.
    I use TaxTips.ca, and click on my province of residence.
    (In this example, let’s assume your marginal tax rate is 33%)
  1. Divide 1 by your marginal tax rate (1 / 0.33 = x)
  2. Then subtract 1 from that answer (x – 1 = y)
  3. Take the final answer (y) and divide it into the amount of money you will contribute to your RRSP before the investment loan ($ / y = the amount you should borrow to invest in your RRSP)

For example, let’s say Pat has $5,000 to invest in her RRSP and Pat is in the 33% marginal tax bracket:

  • 1 / 0.33 = 3.03
  • 3.03-1=2.03
  • $5,000 / 2.03 = $2,463

Based on these calculations, Pat should borrow $2,500 and invest this sum, along with the $5,000 he saved, into her RRSP. This $7,500 RRSP contribution will provide a tax refund of $2,463, which she then uses to pay off the investment loan.

Remember, unlike loans for non-registered investments, interest on investment loans used for registered plans, such as RRSP or Tax-Free-Savings-Accounts, are not tax-deductible.

What types of investments can I hold in my RRSP?

If you’re pushing up against that February 29 deadline or you just don’t know what to invest in, the easiest thing to do is to open and add cash to an RRSP high-interest savings account or just contribute money into your RRSP account (without actually buying or investing in anything). 

Once the pressure is off, you can see what type of investments would work best in your RRSP, based on your financial plan. 

If you don’t have a financial plan and you don’t want to keep the money in a high-interest account, you can opt to hold the following types of investments: 

  • Guaranteed Investment Certificates (GICs)
  • Exchange-Traded Funds (ETFs)
  • Mutual funds
  • Real estate investment trusts (REITs)
  • Bonds (both corporate and government-issued)
  • Stocks (securities) that are listed on a designated exchange, such as the TSX or the NYSE
  • Self-directed mortgage (this is a more complex strategy, and best down after seeking advice). 

Finally, if you want to get an idea of how different contribution amounts to your RRSP will impact your refund, use this simple tax calculator from EY. 

For a rundown on the basics of the RRSP, read this MoneySense article. If you’re in the market to open an RRSP account, check out the ranking of the best savings accounts in Canada

Got a personal finance, tax or real estate question? Ask RK
Romana King
Romana King

Romana King is an award-winning personal finance writer and the current director of content for Zolo. King has contributed to business and lifestyle publications including CBC.ca, Toronto Sun, Maclean’s, MoneySense, Globe & Mail Custom Content Team, and Toronto Star. She is a passionate speaker about financial education and engages her audience on a variety of personal finance topics from kids and money, home buying and selling tips, and estate and investment planning. King won the 2015 SABEW Business Journalism award and is currently nominated for a COPA 2019 award, Best Service Article, for her annual project Best Deals in Real Estate. As editor of CI Top Broker, King guided her magazine to obtain its first KRW Business Journalism nomination, and she was part of the small team in 2011 that helped MoneySense win Magazine of the Year at the 34th annual National Magazine Awards.

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