We always hear a lot about RRSPs at the beginning of each new year. But what exactly is an RRSP? It stands for “registered retirement savings plan”, which means you can open a separate savings account with your bank, through a financial planner, a discount brokerage platform or a robo-advisor. An RRSP is very commonly used as a tax reduction tool. To learn more about RRSPs, read this article.
So why the frenzy surrounding them at the beginning of each year? The deadline for contributing is 60 days following the end of the previous tax year for which you are completing a tax return. This occurs towards the end of February or the beginning of March, depending on working days and leap years. Here are four advantages of contributing to your RRSP – three of which have nothing to do with your retirement.
A source of funding to buy a home or pay for your education
You can withdraw up to $25,000 from your RRSP to pay the down payment on the purchase of your first home (or another home if you haven’t bought a property in 5 years) thanks to the Home Buyers’ Plan (HBP). You can also withdraw up to $20,000 (with an annual limit of $10,000) from your RRSP to pay for your studies or those of your spouse thanks to the Lifelong Learning Plan (LLP), as long as you repay that amount in full back to the RRSP. The repayment period is 15 years for the HBP and 10 years for the LLP and you must begin repaying in the second year following the withdrawal from the RRSP for the HBP and either from the second or fifth year for the LLP, depending on your tax return.
Since an RRSP is, by definition, money saved and invested to grow for retirement, you can withdraw a non-taxable amount from it in order to buy shares in a private company, without restriction on what stage the company is in, so this is good news if you’re just starting out. Your investment in your business can therefore be considered as an RRSP contribution, taxable if withdrawn and without needing to be repaid, unlike the HBP and the LLP, which are discussed above.
You and those related to you, that is to say members of your family, cannot own more than 10% of the shares of the company for a maximum of $25,000. Otherwise penalties apply as soon as one of the rules is no longer met, such as a 50% tax on the investment and 100% on the income generated, until such time the situation is remedied. Keep in mind that it is impossible to hold only 10% if you have full control of your business.
Such a structure can, on the other hand, be expensive and complex to set up and could be less attractive for trustees if the amounts involved are minimal. Eligible businesses are unlisted, Canadian-controlled, and use 90% of the fair market value of their assets to actively operate a business. Businesses that are operated primarily to generate income from property such as rent, interest or dividends are not eligible.
It’s important to underline the risk, in terms of diversifying your investments, that such an investment would present as such a large sum will depend solely on the success of a single company. Additionally, if the business goes bankrupt, you won’t be able to deduct the loss from your taxes, or replace the amount in your RRSP.
Another challenge is to determine the market value of the private company’s shares not traded on the market when the time comes to transfer them to the registered retirement income fund (RRIF). For example, if they no longer meet the criteria for an RRSP-eligible investment on the day of your retirement or if you want to make a swap between these shares and another investment at fair market value. This financing strategy has its advantages, but also its risks.
RRSP contributions are tax deductible, which results in a reduction in tax payable for the current year and often, consequently, in a refund of taxes, therefore additional cash, that you can invest, save or spend as you see fit.
You must, however, make sure you don’t exceed your maximum contribution amount, in order to avoid any penalty. The allowable annual contribution is 18% of the income earned in the applicable tax year, up to a maximum of $25,370 for 2016 (update). An expert can determine the optimal amount to contribute for the tax year in question. You can contribute to your spouse’s RRSP and deduct that contribution from your own taxable income, or carry over your unused contribution amount to subsequent years.
The primary purpose of an RRSP, as mentioned above, is to save for retirement. These savings are invested and generate tax-sheltered returns that accumulate over the years, as long as they remain in the RRSP. They will be taxable as soon as they leave it. The return increases if you contribute at the beginning of the year or make instalments throughout the year, compared to waiting until the end of the year to contribute.
It should be remembered that this is a tax deferral tool, which is used to postpone the taxation of savings and their returns when you withdraw these sums from the RRSP, therefore at retirement.
One of the fundamentals of finance is that “a dollar today is worth more than a dollar tomorrow” because a dollar today has not suffered the inflation of tomorrow and can be invested today to generate a return until tomorrow, hence the advantage of deferring the tax for so many years. In addition, in general, many people have lower incomes when they retire and are therefore taxed at a lower rate at this stage of their lives.
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