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.
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.
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.
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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.
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.