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Using a Registered Retirement Savings Plan (RRSP) to save for retirement, to buy a home, or fund an education is meant to be an easy way to earmark funds for the future. But the accompanying tax and contribution requirements are confusing for many. Here, we answer some of your top RRSP FAQs:

How much should I contribute to my RRSP this year?

There’s no hard and fast rule. The goal for most people is to contribute enough so that when you retire, you can maintain a similar lifestyle to what you currently enjoy.

Although there’s considerable debate about the exact percentage, most experts suggest that you’ll need 50% to 70%of your current income to accomplish that. The maximum you can contribute to your RRSP each year is 18% of your income, and if you’re managing anything close to that, you’re in great shape. Realistically, assuming you’re not carrying stacks of debt, contributing 10% to 12% of your pre-tax income each year is a good target.

Why do I seem to have so little RRSP room to work with?

Either you didn't make any money or you're in a really good pension plan. Chances are, it’s the latter.

First off, check your Pension Adjustment – a number that puts everyone on an equal footing in terms of annual RRSP contribution room. Designed to reflect the value of the pension benefits you've built up in the company plan, it reduces your annual RRSP contribution limit since you're already earning pension benefits at work. Your employer is required to calculate your PA and report it to the CRA on your T4 each year. The CRA then takes 18% of your earned income for the year (up to the maximum limit) and reduces it by your PA to determine your RRSP contribution limit for the following year.

If I have very little earned income, does an RRSP contribution still make sense?

An RRSP is low priority here, largely because there’s no tax savings. In fact, many low-income Canadians actually have less to gain from making an RRSP contribution than they think, particularly as they get older.

Potential investors who expect to receive the federal Guaranteed Income Supplement — currently available to Canadians earning less than $17,088 a year and couples with joint incomes under $22,560 — should probably think twice about RRSPS, for instance. That’s because, for many low-income retirees, a bit of extra income from RRSPs can actually erode their standard of living since it counts against their GIS, which is reduced by 50 cents for every dollar of  retirement income above the threshold.

How much tax will I save by using up both my current and past contribution room?

The total contribution will be deductible. If you’re in the highest tax bracket, you might see as much as a 48% reduction in tax, depending on the province you live in. If you don't have enough income to make deducting the entire amount worthwhile, you can carry it forward and deduct in a subsequent year.

Why wait? Because you think your income, and therefore your tax bracket, is likely to go up in the future. This might include a young physician completing a residency, for instance. Timing does matter. For someone in Ontario, a sizeable contribution might reduce their marginal tax bracket from, say, 48% to the lowest 20% bracket. This means that some of the contribution only produces half of the refund produced from the first dollar of contribution.

Should I max out RRSP contributions or pay down the mortgage?

The truth is, there’s no definitive answer to the mortgage/RRSP debate.

That’s why so many people opt for making RRSP contributions as early as possible and then using the tax refund to reduce their non-deductible debt. The major factors to consider are the mortgage interest rate and amortization, the expected return in the RRSP, how long you’ve got left to invest, your ability to capitalize on mortgage prepayment privileges, and your prognosis for housing prices.

Every time you make an extra mortgage payment you reduce the amount owed on the principal. If your mortgage interest rate is 3%, paying it off faster is like getting a guaranteed after-tax 3% return. If you don’t think your RRSP will match that, then working on the mortgage may be the preferred option.

If you’re looking at credit card debt though, which generally carry horrendous interest rates, then the RRSP argument really loses steam. Paying down a double-digit consumer loan results in a guaranteed return that’s likely greater than anything you’d currently earn in an RRSP.

How much tax will be withheld if I take some money out of my RRSP?

Unless you’re transferring the money to a RRIF or an annuity, or taking advantage of the Home Buyer's Plan or The Lifelong Learning Plan, expect to be taxed in the year you receive any RRSP funds.

At the same time, realize that you’re never going to get all your money up front no matter what you do. All financial institutions are required by the Canada Revenue Agency to charge applicable withholding taxes on lump sum retirement withdrawals. This is not your total tax liability though; it’s just a down payment on what you owe. The money you withdraw is also added on to all of your other income, which may result in another tax bite the following April.

Upfront, expect to be hit with a 10% charge on the first $5,000, 20% on amounts between $5,000 and $15,000 and 30% on amounts over $15,000.

Gordon Powers

A long-time fund company executive, Gordon Powers now heads up the Affinity Group, a consulting firm focusing on retirement readiness. Gordon was a columnist for the Globe & Mail and Morningstar for many years and is also currently a columnist for Investment Executive, Canada’s national newspaper for financial advisors.

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