5 Common Myths About RRSPs
RRSPs have been around for several decades enabling investors to save for their retirement while deferring taxes paid. Everybody knows the rules by now – or do they?
Here are some common myths and misconceptions about RRSPs.
RRSP Myths
Myth #1: You have to be over the age of 18 to contribute to an RRSP.
Anyone living in Canada who has earned income should file a tax return – regardless of age – to receive contribution room. That includes children with flyer routes, those who babysit, and kids who have promising singing careers.
There’s little point in most children claiming the RRSP deduction because little or no tax will be owed, but the benefits of making a contribution make it worthwhile to file a return.
Related: RRSP or Mortgage – What to do with your Tax Refund?
Consider a 12 year old who makes a $500 contribution each year until age 18 and then stops. At a 5% annual return he will have $33,000 at retirement. Of course, the savings habit will be ingrained early on, and he will be well on his way to a substantial retirement nest egg.
The second benefit is that a child’s RRSP tax deduction can be carried forward indefinitely, so when he does start working full-time, he’ll have deductions he can use to offset the tax on his income then.
This leads us to Myth #2.
Myth #2: You have to claim your RRSP deduction each year.
Most people do take the deduction for their RRSP contribution right away. Sometimes holding off makes more sense.
Related: Is An RRSP Loan Necessary?
Take, for example, someone who goes back to school in September. Since her income for that year will be reduced, her marginal tax rate will also be lower. Claiming the deduction then would result in less of a tax saving.
It would be better to hold the deduction for when she returns to work full time and her taxable income increases.
Myth #3: You can withdraw from a spousal RRSP three years after the deposit
The “3-year rule” is commonly misunderstood. It is not three years after the initial contribution, nor can you withdraw any money while still keeping contributions up to date, without incurring tax in the contributor’s hands.
The rules are based on calendar years.
For example, if you made your Spousal RRSP contribution for the 2010 tax year by December 2010, and it was the last contribution made to that, or any other spousal account, you can withdraw funds as soon as January, 2013.
If you waited until the first 60 days of 2011, you will have to wait until January 2014 – a whole year later – before the withdrawal would be taxed in the plan holders hands.
Related: Should You Make RRSP Contributions If You Have A Pension?
Myth #4: You can no longer contribute to an RRSP if you are over 71
What if you are still generating income? Are you out of luck? Perhaps not.
In early December of your last year to contribute, put in an additional amount, based on your earned income. If that puts you over the $2000 allowable lifetime limit, you will incur a 1% per month fee on the excess RRSP over contribution – just one month – then you can deduct in the subsequent year.
Also, keep in mind that contributions to a spousal RRSP are based on your spouse’s age not yours, so if your spouse is 71 or younger, you can still contribute on his or her behalf and take the tax deduction.
Myth #5: You must convert your entire RRSP to a RRIF when you turn 71
It is true that you must convert your holdings by the end of the year in which you turn 71. You are then required to withdraw a minimum amount each year starting the year after the RRIF is established.
You can, however, convert a portion, or the entire amount at any earlier age.
Many financial institutions charge a fee for regular withdrawals from an RRSP, but not for withdrawals from an RRIF – contact them for a fee schedule.
Related: Do You Have A Locked In RRSP?
There’s not much benefit for converting the funds prior to age 65, unless you need the money. At age 65, though, you can take advantage of the pension income tax credit on your tax return and pension income splitting with your spouse.
Some people keep their RRSP account for further contributions, and just convert enough to their RRIF in order to generate enough income to qualify for the credit.
Income splitting is beneficial when you’re calculating your OAS amount and any potential clawbacks.
I get confused by that three year rule every time, so I just forget about it for now. Useful info to know, especially given the year is almost over!
This must be a Canada thing because I’m from the USA and I don’t even know what it stands for!
@Money Beagle: Registered Retirement Savings Account is somewhat comparable to your IRA.
Are there common misconceptions about the rules for that product?
Two comments. For a 12-yr-old to contribute $500 to an RRSP, he/she would have had to make almost $2000 at the age of 11. Not likely. But I do very much agree with kids claiming their income in their teens (or younger if they have it) so they have more RRSP room (my kids did) and contribute and claim later. Contributing is important because that money grows tax-free).
As for that $2000 overcontribution. It isn’t taxed as an overcontribution as long as it isn’t over $2000 (see your own reference). So put that $2000 in at the start of the time you’re contributing to your RRSP (in your teens) and watch that grow tax-free. Don’t wait until your last year to contribute. You could put more money in then (and take the penalty), but I wouldn’t do that.
@Tracey H: When my oldest son was 12 he averaged roughly $100 a month from his flyer route. That was in the late 80’s so it’s not really that much of a stretch to earn $2000 in a year for an enterprising youngster.
In any case, the example is just an illustration and the constant amount made the math easier. Presumably a 16 year old with more employment opportunities would earn more than the 11 year old who mows lawns as a summer job.
You are correct about the over contribution. There is a life time $2000 limit that doesn’t incur any penalty.
The section should read: In early December of your last year to contribute, put in an additional amount, based on your earned income. If that puts you over the $2000 allowable lifetime limit, you will incur a 1% per month fee on the excess over contribution – just one month – then you can deduct in the subsequent year.
I guess my mind started wandering and fell into my own myth 🙂 Thanks for pointing out the error.
Editor’s note: I’ve updated that section.
“Myth #3: You can withdraw from a spousal RRSP three years after the deposit.” I didn’t know this but it’s good news. That makes the income splitting strategy of contributing to a spousal RRSP, and then after the spouse goes on parental leave, he/she withdraws the money when they’re at a low marginal rate somewhat more attractive, because it only takes about 26 months of effective foresight/planning, not 36 months like I’d assumed. Reminds me of the Border’s tariff rules — people don’t know that you can potentially use a 48 hour quota in only 25 hours. Cross the border at 11:30pm (date of entry doesn’t count). Any day thereafter or portion thereof counts as a full 24 hours. So you stay until the next day’s midnight, cross 5 minutes after midnight, and bam, 1.14L of alcohol, 50 cigars, and hundreds more dollars in shopping.
“Myth #5: You must convert your entire RRSP to a RRIF when you turn 71” I did know about the $2000 lifetime overcontribution limit thanks to “The Beginner’s Guide to Saving and Investing for Canadians”. But I never thought of this for contributing a little past age 71 – pretty genius. I’d only thought of the strategy raised by Tracey H, but I passed. The $2000 overcontribution limit is a margin of error as far as I see it. I’d rather keep it, and know I’m not going to get dinged (for example if I need to suddenly do another pension buy-back), rather than pocket the $400 refund now. If I make it to 71, then when I’m old and wrinkly I’ll remember this post and do the overcontribution lol. Expensive peace of mind, but peace of mind nonetheless.
The 1.14L of “alcohol” I meant as “liquor”. You can alternately bring back 2 bottles of wine or a 24 of beer if I recall, but obviously check relevant regulations.
@Joe: A Spousal RRSP is a good income splitting technique not only to equalize pension income but, as you mention,for other periods of low or unemployment. You just have to stay within the rules to make it work.
As for the $2000 over contribution limit, you are right that it is really intended as a margin of error, but it can be used at any time. See my reply to Tracey H for the correction of my original statement.
Thanks so much for the great post! As a mortgage broker, I don’t talk about RRSPs too much with my clients, but they do come up every now and again and I’ve had to educate myself quite a bit on them. I think you’ve pinpointed the 5 biggest myths beautifully. I know they’re the ones I usually have to end up explaining. Over and over again.
Has anyone actually opened up a RRSP for a child? I do not know of a financial institution that will open a RRSP account for a child until they are of legal age.
@Jim a friend of mine did but any tax savings are negated by the fact most children’s income isn’t high enough to be taxable. CRA does allow an RRSP to be opened for children though.
about the $2000 over contribution limit penalty, sometimes CRA is actually forgiving, I had an over-contribution due to a mixup on my work’s PA over several thousand over that, and they allowed me to carry this for several years until I could reduce it without penalty, sometimes they are human