If you ask me what are the greatest contributors or tools of getting rich in Canada?, then I can confidently say they are Tax Free Saving Account (TFSA) and Registered Retirement Saving Plan (RRSP) (For US citizens, they are 401K, IRA, ROTH IRA etc…). I have explained the benefit of TFSA in my previous post so let’s go over RRSP today.
Why buy an RRSP?
- Contribution is tax deductible- That means you can get cold hard cash back when you file your tax return if you maximized contribution
- The higher your marginal tax rate, the higher your tax savings that means you can claim more if you made more money
- Tax Deferred compounding- Income and capital gains generated in RRSP is compounded tax free and is taxed only when you withdraw from the plan. It is a retirement vehicle so it is likely you would be retired and in a lower tax bracket. This means you can build up a huge tax deferred earnings inside RRSP.
- Spousal RRSP contribution- You can contribute to your spouse or common law partner’s RRSP and get deduction. It is an awesome idea if you expect your spouse to be in a lower tax bracket than you when you couple is retired.
- This can make pension credit available for both of you
- This can reduce your family’s total tax bill
- This can reduce your exposure to Old Age Security (OAS) clawback
How much and when to contribute?
- 18% of your previous earned income to a maximum of $24,270
- Contribution must be made within 60 days of the end of the calendar year. So March 2 2015 for 2014 taxation year
- If you haven’t contributed then you can make up the difference in the current taxation year by utilizing accumulated contribution room
- Complicated?- Check Notice of Assessment that CRA send to you as it tells you how much exactly you can contribute.
What are the effective ways of utilizing RRSP?
- Contribute RRSP early in the year rather than waiting at the end of the contribution year to get income sheltering and dollar cost averaging
- Think about contributing RRSP at regular intervals. If you do then consider submitting form T1213 to CRA for authorization to reduce your income tax withholding reduced from your employer’s paycheque. Once authorized, your employer will be able to reduce the amount of taxes withheld from your pay.
- Home Buyers Plan (HBP)
- You are allowed if you are first time homebuyers to withdraw up to $25,000 on a tax free basis to purchase a home.
- The loan repayment must be made within 15 years.
- You are considered to be a first time homebuyer if during previous 4 years of the withdrawal and up to 30 days prior to the withdrawal, you and your spouse haven’t owned a home.
- You can participate a second time if you have paid back previously withdrawn under HBP and still qualify for the first time homebuyer (4 years rule)
- Tax free RRSP withdrawal on Higher Education
- Tax free withdrawal is available for full time training and education for you and your Spouse
- Withdrawal is limited at $10,000 per year up to 4 years
- Total cumulative limit of $20,000
- Must be enrolled as full time student in a qualifying education program of at least 3 months at a qualifying schools
- Withdrawal must be repaid within 10 years and the repayment must be started within 6 years at required amount.
- It is not mandatory to deduct your contribution in the year you have contributed. If you expect you will be in a higher tax bracket then you can consider delay the deduction until that time. By delaying it you will be able to save a bigger tax savings.
- You are able to carry forward unused portion of RRSP contribution room to future years
- When you do not have sufficient fund to invest both RRSP and TFSA and if you are in a lower tax bracket, then I would suggest you to use TFSA.
- Remember, if you borrow money to invest in RRSP, the interest charged from the loans is not deductible.
What happens if you over contribute?
- You are permitted to over-contribute RRSP for up to $2,000
- If you go beyond that level then contact your tax accountant to determine what steps you can take as a penalty tax of 1% per month applies to the overcontribution beyond $2,000. You may be able to file certain forms to waive penalty.
- US Stocks- RRSP is not subject to withholding tax deductions on US stocks. You can avoid paying withholding taxes. Yay! Foreign dividend income, interest income and capital gain grow tax free but will get taxed when withdrawn. Take advantage on lucrative US stock market
- Invest in diversified ETFs and solid dividend paying blue chip companies to maximize compounding. Don’t forget to set up DRIP.
- Keep Canadian REITs in RRSP to avoid tax complication as REIT is not taxed at company level but shareholders’. That results a headache on tax filing as REIT distribute interest, dividends, capital gains etc…. By investing in RRSP, you can avoid all the tax consequences
That’s it. That probably was a lot of information to digest. Keep it simple folks. Utilize RRSP. Make contribution to it, get a tax refund, invest the refund to RRSP and TFSA and don’t even look back.
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