February 10, 2012
With the February 29, 2012 deadline for 2011 tax-deductible Registered Retirement Savings Plans (RRSP) contributions coming up soon, now is a good time to weigh the advantages of tax-assisted savings plan options that may be available to you, especially if you haven’t made your current contribution. Depending on your personal situation, RRSPs, Tax-Free Savings Accounts (TFSA), Registered Education Savings Plans (RESP) and Registered Disability Savings Plans (RDSP) can offer significant tax benefits for your investment savings. In addition, self-employed individuals and employees of small businesses may soon have a new savings plan variation once the federal and provincial governments pass legislation for the new Pooled Registered Pension Plan (PRPP).
This TaxNewsFlash-Canada summarizes some of the key features of these tax-assisted savings plans, and compares their benefits to help you decide which ones are best for you.
How do tax-assisted savings plans work?
All tax assisted savings plans offer your money or investments the opportunity to earn interest and grow in a tax-free environment. However, contribution limits and the tax treatment of contributions and withdrawals vary between the plans.
RRSPs and TFSAs — Which is best suited for you?
Which plans you choose for your savings will depend on your circumstances. Generally, if you have enough resources, you should invest in all the relevant plans. For many Canadians, the most relevant plans will include RRSPs and TFSAs. Both these plans can help you save for retirement or other reasons but it’s important to note the differences between them.
Generally, RRSP contributions are tax-deductible but the contributions and investment earnings are taxed when you withdraw them. A TFSA is more like an RRSP's mirror image: TFSA contributions, which can include investments you already own, are not tax-deductible but withdrawals of contributions and investment income are tax-free.
While both RRSPs and TFSAs should often both be components of your retirement and savings plan, your best tax strategy may depend on your current tax bracket and the one you expect to
be in when you retire.
RRSP contribution limits
Three factors limit the amount you can contribute to an RRSP: a dollar limit ($22,450 for 2011 and $22,970 for 2012); a percentage of the previous year's "earned income" (18%); and your pension adjustment, which represents the notional value of pension contributions made by you and your employer in the year.
Contributions to an RRSP are deductible for any given year if they are contributed in the year or within 60 days after the end of the year. So if you contribute by February 29, 2012, you can get a deduction for your 2011 tax return.
Generally, you can continue to make contributions up until the end of the year in which you turn 71. However, if you are over 71 but your spouse is 71 or younger and you have “earned income” in the previous year, you may be able to still claim a deduction for a spousal RRSP contribution.
TFSA contribution limits
You can contribute up to $5,000 per year to a TFSA, as long as you are 18 or older and resident in Canada, starting with 2009, the first year TFSAs were available. If you have made no contributions to date, you can contribute $5,000 for each of 2009- 2012, for a total of $20,000. You can carry forward unused contribution room indefinitely, just as with an RRSP. Assuming you have contribution room, it almost always makes sense to invest in a TFSA if you have money sitting in a bank account earning taxable interest.
You can make a tax-free withdrawal from a TFSA at any time. When you make a withdrawal, the amount withdrawn is added to your contribution room in the next year and can be re-contributed in the future. Investment income earned in your TFSA works the same way. Generally, RRSPs and TFSAs are allowed to hold the same qualified investments.
You could potentially contribute much more than the contribution limit annually and earn more tax-free investment income. For example, if you invest a $5,000 TFSA contribution in the stock market and your share investment appreciates rapidly to, say, $50,000 you could sell the shares and realize the $45,000 tax-free capital gain in the TFSA, withdraw the $50,000 cash proceeds and still be able to recontribute the full $50,000 amount to the TFSA along with any other unused TFSA contribution room in the following year or later.
RRSPs vs. TFSAs
If you expect your future income to fall into the same tax bracket as your current income, the tax benefits of a TFSA and an RRSP will be similar. That is, the value of the tax deduction for an RRSP contribution will generally equal the value of withdrawing funds tax-free from a TFSA.
If you expect your future income to fall into a lower tax bracket than your current income, an RRSP investment can provide a tax advantage because the tax savings from the deduction you get today will be more than the tax you will eventually pay when you withdraw the money from your RRSP in a lower tax bracket.
If your income falls into a lower tax bracket now but you expect it to be higher in the future, a TFSA offers a greater tax benefit because you would pay a higher tax rate on RRSP withdrawals in the future than you would pay today on the income you contribute to the TFSA when you are in a lower tax bracket.
You should also consider the following factors:
- While interest on funds borrowed and fees incurred to invest in either a TFSA or an RRSP are not tax-deductible, only a TFSA can be used as collateral for a loan.
- Capital losses realized in a TFSA cannot be claimed against capital gains realized outside the TFSA (the same is true for RRSPs).
- While TFSAs can be maintained for your entire lifetime, RRSPs must be wound up by the end of the year in which you turn 71.
- If you're weighing whether to put funds toward your TFSA, RRSP or mortgage, your best bet may be to make your RRSP contribution and devote the related tax savings to paying down your mortgage.
Registered Education Savings Plans
RESPs are tax-assisted savings vehicles that can help you build an education fund for your child or grandchild (or a friend’s or relative’s child) by allowing you to earn investment income in a tax-deferred environment. You can set up an individual plan with organizations such as life insurance companies, mutual fund companies and financial institutions or you can enroll in a group plan offered by a nonprofit scholarship or education trust foundation. If your child goes to college or university, the RESP provides funds to help cover the child’s expenses.
Unlike RRSPs, contributions to an RESP are not tax-deductible to the contributor. However, the income in the plan grows tax-free, so RESPs benefit from tax-free compounding of investment income. When the child withdraws the funds, the income portion will be taxable to the child. As a student, the child/beneficiary will probably not have much other income and will be eligible for the tuition and education tax credits, so he or she will likely pay little or no tax. The investment income payments from an RESP are all taxable as regular income, even if the investment income was earned as dividends or capital gains, which are normally taxed at a lower rate. In addition, the capital portion of your RESP contribution remains tax free when withdrawn.
RESPs can be effective education savings vehicles, especially due to the availability of Canada Education Savings Grants (CESG). Under this program, the government will provide a grant of 20% on the first $2,500 of annual contributions made in a year to an RESP, giving you an easy extra 20% return on your first $2,500 of contributions each year per beneficiary. For low and middle-income families, the CESG grant may be even higher. The maximum lifetime grant is $7,200 per beneficiary. The overall lifetime limit for RESPs contributions is $50,000 per beneficiary.
Registered Disability Savings Plans
If you have a child with a disability who is eligible for the disability tax credit, you can save for that child’s long-term security with an RDSP. Under these plans, which are similar to RESPs, contributions to RDSPs are not tax-deductible, but investment income can be earned in the plan tax-free. Investment income, but not contributions, will be taxable to the beneficiary when it is paid out of the RDSP.
Anyone can contribute to an RDSP and there is no annual limit on the amount you can contribute. Contributions on behalf of any one beneficiary, however, are capped at a lifetime maximum of $200,000. Contributions can continue to be made until the end of the year the beneficiary turns age 59.
A parent or grandparent’s RRSP funds can be transferred tax-free on their death to the RDSP of the RRSP holder’s financially dependent infirm child or grandchild, subject to the child or grandchild beneficiary’s $200,000 lifetime contribution limit.
The beneficiary must begin receiving payments from the plan by the end of the year he or she turns age 60, subject to maximum annual limits based on life expectancy, the age of the beneficiary and the value of the plan’s assets.
These plans also qualify for Canada Disability Savings Grants (CDSG), which are similar to CESG for RESPs. Under this program, your RDSP contributions earn CDSGs at matching rates of 100%, 200% or 300%, depending on family net income and the amount. The deadline for contributions to an RDSP is December 31.
An RDSP beneficiary can receive up to $3,500 of CDSGs in their RDSPs annually and up to $70,000 of CDSGs in their RDSP over their lifetime. CDSGs can be paid to an RDSP until the year in which the beneficiary turns age 49. Starting in 2011, unused entitlements to CDSGs can be carried forward for up to 10 years.
Pooled Registered Pension Plans
If you are self-employed or employed by a small business and don’t already have a company pension plan, you will soon have a new option for tax-effective retirement savings. PRPPs will offer the benefits of participating in a large pension plan like the defined contribution plans many large companies offer.
PRPPs’ potentially large pooled funds may allow plan members to benefit from lower investment management costs. Along with these potential cost savings, PRPPs will offer the same tax benefits as RRSPs. PRPP contributions will be tax-deductible. Individuals’ combined PRPP contributions and RRSP contributions will be subject to the current annual RRSP limit of 18% of the previous year’s earned income, up to a maximum of $22,970 for 2012. Any employer contributions are included as part of the employee’s contribution room.
PRPPs provide the same tax-deductible contribution room for retirement savings as RRSPs, but with a different investment vehicle. Employees will be able to transfer their savings between PRPPs, so they’re not wedded to one plan.
We expect PRPPs to become available once the necessary federal and provincial legislation has been passed. The Department of Finance says provincial and federal officials are working together to implement PRPPs as soon as possible.
More tips in KPMG’s Tax Planning for You and Your Family 2012
You can find more details on tax-assisted savings plans in KPMG’s Tax Planning for You and Your Family 2012, now available from your KPMG adviser, in bookstores across Canada or directly from the publisher Thomson Carswell (telephone: 1-800-387-5351).
Tax-assisted savings plans should be only one component of your financial planning strategy. Your KPMG adviser can help you to devise a practical and comprehensive investment and tax planning strategy to help keep you on track toward reaching your personal financial goals. For details, contact your KPMG adviser.
Information is current to February 9, 2012. The information contained in this TaxNewsFlash-Canada is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation. For more information, contact KPMG’s National Tax Centre at 416.777.8500.
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