Three common RRSP errors

Fabio Campanella, Special to Financial Post | Jan 23, 2013 4:30 PM ET | Last Updated:Jan 23, 2013 5:45 PM ET

Are you making these RRSP errors?

Are you making these RRSP errors?

RRSP season is upon us, but before you go out and maximize your contributions, let’s take a look at three common RRSP errors Canadians tend to make.

Darren Calabrese/National Post

Darren Calabrese/National PostFabio Campanella

The tax refund your RRSP contribution generates should be thought of as a loan rather than a true refund

Spending your tax refund This has to be the most common RRSP related error, and it stems from a fundamental misunderstanding of the functions of an RRSP. Good tax planning attempts to maximize two elements of your tax liability: First, absolute tax savings and second, tax deferral. An RRSP can aid in achieving both elements, but its fundamental function is a vehicle to achieve tax deferral. The tax refund your RRSP contribution generates should be thought of as a loan rather than a true refund. The reason is that upon the eventual withdrawal of your RRSP funds (presumably in retirement) you will be taxed once again. The smarter move would be to use the refund to contribute to your TFSA, pay down tax-inefficient debt, or simply to save it.

Improper investment allocation
 If an investor has holdings across multiple registered and non-registered accounts, then the allocation of these investments should consider the type of income generated by each component of their portfolio.

In Ontario, top marginal tax rates in 2012 for interest income is 47.97%, eligible dividends is 31.69%, and capital gains is 23.98%. If an investor uses a balanced portfolio approach (say 40% fixed income and 60% equities) it would usually make sense to allocate as much of the fixed-income portion of their portfolio to the RRSP and as much of the Canadian equity portion of their portfolio to their unregistered accounts to take advantage of the vast differences in tax rates that these types of investments trigger.

Over-contribution by small business owners
 If you are the owner of a small business earning active business income in Canada that qualifies for the small business deduction, you may actually be better off avoiding RRSPs altogether. A 2010 report commissioned by Jamie Golombek of CIBC outlined the tax benefits of taking dividends in lieu of a salary and investing the retained earnings of your small business in lieu of RRSPs.

In a nutshell, the report concludes that small business owners are better off taking dividends from their corporations in the amount they need to fund their lifestyles and keep their remaining profits in the corporation as a retirement nest egg. Due to the vast difference between the corporate tax rates and the top marginal personal tax rates in Canada, a massive tax deferral can be achieved using this strategy.

The tax savings can be further amplified if multiple family members are issued shares of the corporation to achieve income splitting. The strategy is effective but not without its drawbacks; Reorganizing a corporation’s shareholdings and structure can attract significant accounting and legal fees, building up non-active business assets in a corporation can disqualify it for the Lifetime Capital Gains Exemption, and investments held in your corporation will not have the same creditor protection your RRSPs can provide you with.

Fabio Campanella , CA, CFP, CIM is a partner at Campanella McDonald LLP