Why not Contribute to your RRSP and TFSA Accounts Early?
RRSPs are very useful for retirement savings as well as other savings strategies such as saving for the purchase of your first home or your tuition. In this article we review the considerations around contributing to an RRSP for future savings purposes.
Contribution deadline
The contribution deadline this year is March 1, 2022. Any contribution made by this date can reduce taxes on your 2021 tax return. However, in the right circumstances there would be value to contributing to your 2022 RRSP.
Some general guidelines
- RRSP room is based on prior year earned income and contributions are tracked from January to December of the current year.
- You are given the opportunity to deduct contributions made in January/February of this year, and last year if not claimed.
- If you have higher income and are in the top tax brackets with no pension or group RRSP plan with your employer, your RRSP room will be as much as the maximum every year. Income of $162,278 will generate the maximum RRSP contribution room of $29,210 for 2022.
- At the start of every calendar year you can contribute to your RRSP based on your expected current year contribution room (maximum amount based on income expected for the year). This gets money in the tax deferred environment as early as possible, so it starts working for you and the power of tax-deferred compounding of investment income is optimized.
- Remember, with this approach, if you make a contribution in January/February 2022 for example, you would still have to report the contribution on your 2021 return. Your Notice of Assessment will show your RRSP room and also, your undeducted RRSP contribution (already made).
The benefit of monthly contributions
What if cash flow prevents the lump sum contribution approach? Another good approach is contributing monthly /regularly to your RRSP. This deploys your contributions into the market regularly so you are buying in at highs and lows and you average into the market, but also importantly you get the money into your account so it is working for you and you’re building toward your financial goals.
Be aware that with tax deferred accounts (such as RRSPs, TFSAs) if you take a loan to the make your contribution, the interest is not tax deductible. Also, if you overcontribute, CRA applies a penalty of 1% per month you are over. Keeping an eye on these rules will prevent unnecessary penalties.
RRSPs are best if you are at a high tax rate
RRSPs are best used if you are at a high tax rate so the tax savings from the contribution is applied at this rate as well. However, in the future, this account must be converted to an income producing account by December 31 in the year you turn 71. Withdrawals are fully taxable. Depending on your total income and withdrawal amounts, they could expose you to a clawback of social benefits like Old Age Security benefit. However, there are other planning items to consider that can mitigate this exposure.
How do TFSAs differ?
TFSAs have not been around as long as RRSPs but have certainly made a place for themselves in your financial picture given the tax elimination on all of investment income on assets in this account.
There is no deduction for contributions, but given assets grow tax free and, there is no tax upon withdrawal, these accounts provide a lot of flexibility. You can contribute to these accounts in line with your contribution room (a set amount annually to individuals 18 years of age and over) and draw down on the funds for various uses such as supplementing an RESP, saving for your children’s education, saving for your parents’ medical needs in the future, or for savings for larger purchases. These funds are also useful to save and build for retirement. There is no age at which these funds must be withdrawn so they can build tax free for your lifetime. And TFSA funds withdrawn can be replaced when you have excess funds.
What’s next?
Tax deferred savings are powerful tools as they provide an environment where investment returns can compound annually without being taxed now nor for many years.
Work with your advisor to ensure you are making the most out of these powerful tools.
