It may make sense to keep some RRSP contribution room unused when a client foresees a one-time income jump that pushes them into a higher tax bracket.mi-vector/iStockPhoto / Getty Images
Many think of unused RRSP contribution room as a missed opportunity, but it can also be considered an asset that clients have in their back pockets to serve as a hedge against out-of-the-ordinary high-income years.
Bonuses, exercised stock options, severance packages, realized capital gains in a non-registered account as well as the sale of a cottage, rental property, or business may boost income temporarily, and the tax deduction that follows an RRSP contribution can help mitigate the effect on taxes.
When a client foresees or experiences a one-time income inclusion that bumps them into a higher tax bracket, Daniel Evans, certified financial planner, money coach and investment coach with Money Coaches Canada in Vancouver, says he considers an RRSP contribution in the context of their taxes today and into the future. “Does it put them in a better position financially, given the assumptions that we’re using?”
The optimal solution is different for every client, Mr. Evans says, depending on all the moving parts of their financial plan and their objectives.
One factor to consider is the alternative minimum tax (AMT) calculation with and without an RRSP contribution. Another is whether clients are planning to leave Canada and become non-residents, which may affect how much money they should accumulate in an RRSP.
Even clients who plan to retire in Canada may not want to end up with very high mandatory RRIF withdrawals that result in clawbacks to income-tested benefits such as Old Age Security and the Guaranteed Income Supplement.
“RRSPs look great on the surface, but, depending on what the client wants to do and their situation, it may not end up being the strategic thing to do,” Mr. Evans says.
The key, he adds, is to ensure clients have sufficient flexibility within a financial plan to accommodate the unpredictable. He also makes sure clients understand that with RRSPs, there’s an eventual tax bill.
He generally encourages clients to invest refunds resulting from RRSP contributions in a tax-free savings account (TFSA) or non-registered account so they’re ready to pay what’s essentially an interest-free loan when it comes due on withdrawal.
Contribute now, deduct later
RRSP contributions and the associated deductions can absolutely help to reduce “tax volatility,” says Andrew Feindel, portfolio manager, senior wealth advisor and senior investment advisor with Richardson Wealth Ltd. in Toronto.
However, he says, “Most people should try to max their RRSPs when they can.”
One way to have your cake and eat it too is to contribute anyway – to either an RRSP or a spousal RRSP – but save the deduction for a future year.
That way, money starts compounding on a tax-deferred basis within the RRSP – and the deduction is available for an anticipated future high-income year.
Mr. Feindel says clients should think of the unused deduction as an unexercised financial option that’s available to use when it will have the biggest impact.
Assuming a client decides to make an RRSP contribution to offset their taxes in a high-income year, Mr. Feindel says it’s important to avoid overcontributing.
In addition, for in-kind contributions, he cautions that capital gains trigger taxes on the deemed disposition, but capital losses cannot be claimed. The only way around this is to sell an investment with a capital loss outside the RRSP (and claim the loss), contribute the cash to the RRSP, and then wait 30 days before repurchasing the investment to avoid the superficial loss rule.
“Work with a [financial] planner who can rank if the RRSP makes sense in that given year, because it’s not the only vehicle,” Mr. Feindel says.
Depending on a client’s situation, they may benefit more from contributing to a first-home savings account, which also offers a tax deduction, or a TFSA, a registered education savings plan, or a registered disability savings plan, if applicable.
Tax savings are a bird in the hand
Jason Nicola, wealth advisor and client relationship manager with Nicola Wealth Management Ltd. in Vancouver, says he wouldn’t typically recommend saving RRSP contribution room just “in case.”
“I’d rather see [clients] get that bird in the hand, [so I tend to] recommend that they do the contributions now,” he says.
He also points out there’s a time value to the tax refund. Assuming a client is at a 30-per-cent marginal tax rate, a $10,000 RRSP contribution can result in a $3,000 refund that can be invested immediately and start growing.
That said, it may make sense for someone who has just graduated from college or university to contribute to an RRSP now and bank the tax deduction if they’re confident their income will be significantly higher in 10 years.
An alternative approach is to contribute to a TFSA while income is low, then withdraw from the TFSA to make tax-deductible RRSP contributions when income bumps up into a higher tax bracket. Mr. Nicola notes that results in tax-free (versus tax-deferred) growth for the period of time money is invested in the TFSA.
Beware of human behaviour
Mr. Nicola warns against passing up “plain and simple opportunities, … to just do your retirement savings and get a reasonable tax deduction today, for myriad possible events that might happen in the future.
“What I worry about is that the contribution never happens or the saving never happens,” he says.
Meanwhile, getting more money into an RRSP can serve clients well from a behavioural standpoint.
Mr. Feindel says in his experience, investors tend to feel they should be fully invested within an RRSP, but that bias doesn’t extend to non-registered plans. It’s one more element worth considering when deciding whether to direct additional funds toward an RRSP in a high-income year.
“The RRSP decision shouldn’t be looked at in isolation. It should be integrated with all those other components, [including] human behaviour,” he says. “It’s about mapping a lifetime income arc.”