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Neat things to do with RRSPs

While many boomers expect inheritances, others find themselves providing financial assistance to parents in their senior years

JIM YIH
EXPERT OPINION

When Ottawa introduced a tax-sheltered and tax-deferred investment vehicle in 1957 to encourage people to start saving for retirement, the rules were fairly simple.

But there have been myriad changes since then and, for the average Canadian, it's pretty hard to keep up.

The more than 65 per cent of us who have invested in plans know that we save money on our taxes if we buy an RRSP. But there's so much more to it than just the tax deduction.

Here are some lesser-known facts about RRSPs:

Know your limits

For a while, the RRSP maximum did not change. It was stagnant at $13,500 or 18 per cent of your previous year's income.(That's less any pension adjustment, plus any carry forward of unused room.)

Since 2003, the RRSP maximum limit has increased from $13,500 in 2002 to $14,500 in 2003 to $15,500 in 2004 and it will be $16,500 in 2005. This means that you can earn up to $91,667 before you max your RRSP contribution at $16,500.

Borrow to buy a home

If you are a first-time home buyer, you may be able to co-ordinate your RRSP strategy with the purchase of a new home. Essentially, you can borrow up to $20,000 from your RRSP (per person) to buy your first home.

For example, Kent is planning to buy his first house within the next 18 months. He has more than $20,000 in unused RRSP contribution room and has some money saved for either a house or the RRSP.

Which is better? Why not do both? Let's say Kent puts the $20,000 into the RRSP, he will get a 36-per-cent tax savings, or $7,200. Now, Kent can turn around and not only use the $20,000 under the first-time home buyers pan but also have another $7,200 for the purchase of the home.

Borrow to go back to school

Not only can an RRSP be used for retirement or to buy your first home, it can also be used to fund you or your spouse's education under the Lifelong Learn Plan. Similar to the Home Buyers' Plan, any withdrawals for the purpose of training or education are tax free, provided you use the government form RC96.

You can borrow up to $20,000 but you must pay it back over a period of no more than 10 years. If you do not repay, the amounts will be added to your income in the year it was due and thus taxed at the marginal tax rate.

In both the home buyer's and the learning plans, there are lots of little rules so make sure you visit the government website www.cra.gc.ca for more information.

Understand withholding tax

When you put money into the RRSP, you get a tax break. But when you take money out, you have to pay the tax. When you are taking money out of an RRSP, be aware of withholding tax.

Essentially, the government says that any withdrawals less than $5,000 will be subject to a withholding tax rate of 10 per cent. For example, if you take out $4,000 from your RRSP, you will only get $3,600 because $400 (or 10 per cent) will be sent to the Canada Revenue Agency for taxes withheld at source. If you take out a lump sum between $5,000 and $15,000, you will be subject to 20-per-cent withholding and any withdrawals greater than $15,000 will be subject to 30-per-cent withholding.

The most important point to stress is that the withholding tax rate is not your marginal tax rate. Often people try to minimize withholding tax, thinking that that will be their total tax bill but they get surprised at the end of the year with additional taxes owing.

Defer the deduction

Most people invest in an RRSP with the intent of using the tax deduction immediately. What people don't realize is that they can make the RRSP contribution but save the deduction for a future year.

Why would you want to do that? In case you'll be in a higher tax bracket a year or two down the road. For example, you may be getting a big bonus that's paid in the next year, or you may have received a severance allowance pushing your income higher.

Why not make the contribution at a later date? Because once the money is in the RRSP, you take advantage of tax-deferred investment growth.

Reduce tax deductions

Most people who contribute to RRSPs throughout the year wait until they file their tax return and then get a bunch of money because of the RRSP deduction.

Although that feels pretty good, what you're actually doing is giving the government an interest-free loan with your hard-earned money. That's pretty generous. To avoid that, you can file a request to the Canada Revenue Agency and get less tax deducted from your paycheques. That way, your tax refund will be spread out over every paycheque and you'll have the money more quickly to spend to reinvest.

Make in-kind contributions

In most cases, people contribute to their RRSPs with cash. However, if you are holding non-RRSP investments, such as Canada Savings Bonds, bonds, mutual funds or stocks, you can transfer them to your RRSP in kind or 'as is.'

Sometimes this can be a less painful way of getting an RRSP deduction than having to come up with the cash or take out a loan. Just remember that when you transfer the investment into an RRSP, it's considered a disposition and there may be capital gains if the value has gone up.

Use the over-contribution limit

In 1995, the government reduced the one-time over-contribution limit to $2,000 from $8,000. The limit is designed to provide a buffer in case you make a mistake in calculating your RRSP contributions.

You can use the $2,000 over-contribution to get ahead of the game and take advantage of tax-deferred growth and compounding in the RRSP. But as you get closer to retirement and withdrawals, make sure that you eventually claim the $2,000 as part of your deduction limit to avoid double taxation.

Shelter interest income

When it comes to investing, most people should have a diversified portfolio of fixed-income investments and equities. What fewer people realize is that you should keep fixed-income investments, such as GICs and bonds, inside the RRSP and equities, such as stock, outside the RRSP.

That's because the interest on fixed-income investments is fully taxable while the capital gains on equities is tax preferred because only 50 per cent of the growth is taxable.

So you might as well put the fully taxable investment income inside the RRSP to shelter it and take advantage of the tax-preferred investment income outside the RRSP.

Jim Yih is an Edmonton-based financial adviser and author of Mutual Fundamentals and Seven Strategies to Guarantee Your Investments.

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