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Deadline to Offset Taxes with Pension Contributions Looms

Contributed by Emma Hearn
February 7, 2014

A deadline to offset hefty tax burdens through contributions to a Registered Retirement Savings Plan (RRSP) is fast approaching for millions of Canadians, as well as Americans with dual citizenship. Only a few weeks remain before the opportunity to save thousands of dollars on taxes closes on March 3rd, 2014. An RRSP provides Canadians, US nationals residing in Canada, as well as permanent residents who earn anywhere above the lowest tax bracket the opportunity to save for their retirement, while reducing their taxable income each year. When the RRSP is gradually withdrawn following retirement, most pensioners are taxed on these withdrawals at the lowest tax bracket, as they no longer have other major sources of income, beyond a modest government or private pension plan. There are, however, some important rules of thumb to follow when it comes to using RRSPs to offset taxes, in order to maximize savings and to avoid losing the full benefits as a result of hasty tax planning.

Using Group RRSPs as Ideal Tax Shelters

As part of comprehensive fringe benefits plans, many Canadian employers match the RRSP contributions of their employees up to a certain limit. The money that is earned  through these matched contributions forms what is called a group RRSP and this frequently serves as a savings plan in private sector companies that do not offer retired staff full private pensions. One of the most important benefits of group RRSPs is that employees enjoy a tax offset right away, since having the biweekly or monthly RRSP contribution amount automatically deducted each pay period means that a smaller portion of the employee's income is taxed at source. For instance, an employee who earns $3,000 gross per month and who is allowed to contribute up to 5% into a employer-matched group RRSP would have $150 deducted each pay period, while the employer would deposit an additional $150 each month in the employee's RRSP account and - most importantly - income tax would only be charged on $2,850 each month. By the end of the year, the employee will have accumulated $3,600 in a group RRSP account, and this entire balance would remained sheltered from income  tax until the RRSP holder turns 71 years of age. 

The Benefits of Forced Deductions in Difficult Financial Times 

An added benefit of group RRSPs deducted at source is that is serves a de facto forced savings plan, where small amounts are saved throughout the year, rather than requiring the average wage earner to transfer thousands of dollars from their bank account each February, during the mad rush before the March RRSP deadline, when much of this may have been inadvertently spent through the year. Figures published by Scotiabank found that the number of RRSP contributors fell by eight percent in just one year, from 39% to 31% by the end of 2013. According to CTV News, the Bank of Montreal witnessed a similar downward trend, with the number of clients seeking to contribute to RRSPs plummeting from 50% to just 42% in one year. At a time when the number of Canadians contributing to RRSPs has falled to an all time low due to rising debt levels, group RRSPs offer a pain-free and effective way to save, through relatively modest monthly deductions and - most importantly - contributors get to enjoy the tax savings immediately. 

Making Good Use of Maximum Contribution Limits

Group RRSP limits, and the amounts matched by the employer, are usually much lower than the maximum annual tax offset amount regulated by Canada Revenue Agency (CRA). Canadians and permanent residents earning income in Canada can shelter up to 18% of their earnings each year from federal and provincial income tax. For the current tax year, the maximum amount that can be sheltered from tax stands at $23,820. Most importantly, however, even if wage earners are not able to deposit the maximum amount into RRSPs, they can apply unused portions to future years. As such, an employee who manages to deposit $10,000 in one year will still have an additional $13,820 to put aside in the following year, on top of the new allowance for that tax year. The accumulation of unused contributions from previous years is especially useful for students or those on low incomes, as they can make effective use of left-over contribution allowances from earlier years once their revenue enters a higher tax bracket. 

Saving Taxes on RRSP Withdrawals

While Canadians and permanent residents with higher incomes don't face the looming prospect of a return to the 50% tax bracket currently proposed by the opposition Labour Party in the United Kingdom, a lack of careful retirement planning can still result in an unexpected tax burden later in life, not just in the UK, but also in North America. After reaching 71 years of age, RRSP holders must transfer their balance into a retirement income fund, where they will be required to withdraw at least 7.38% in the first year, followed by similar withdrawals in each future year. Some financial advisors note that those who retire with generous private pension plans, as well as those with income above and beyond the federally-administered Canada Pension Plan (CPP) and Old Age Security (OAS) may end up being pushed into a higher tax bracket as a result of the required withdrawal. Being in a higher bracket can also result in deductions in OAS payments, thus jeopardizing part of one's pension. As such, it is often advisable to begin withdrawing from RRSPs a few years before turning 71 years of age if one's income is under $42,707. For example, someone who earns $40,000 at age 62 can consider deducting up to $2,707 per year from their RRSP, without being pushed into a higher tax bracket. This makes most sense for those who reduce their working hours, as they gradually prepare for retirement. 

Setting up an RRSP doesn't have to be a painful process left  to the last minute each February, especially considering that this is also a time when municipal taxes are due in much of the country. A combination of group RRSP contributions throughout the year, as well as knowing when to begin gradually withdrawing these contributions can significantly lower one's taxes, both immediately and also decades from now.  


Tags: tax | retirement | Retire | Retirement | Canada | pensions | employees | investment | business | Tax | tax planning | North America | fringe benefits | United Kingdom



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