Tag: RRSP room

Why RRSP room lags a year behind money purchase pension limits

Why RRSP room lags a year behind money purchase pension limits: Reconciling retirement savings using the pension adjustment

To many, the tax system may seem to work in mysterious ways, sometimes to the point of appearing unfair.  In truth though, fairness is a key principle informing our system, tempered with the real-world practicality of putting that principle into operation.

A visual way to show the contrast in terms of retirement savings would be to look at two savers, one who is a member of a money purchase registered pension plan (MP RPP), and the other making use of registered retirement savings plan (RRSP) room.  On the face of it, this gives the impression of a systemic one-year lag in available contribution room that favours pensions over individual savings. (See table.)

But is this reality or illusion?  An explanation of the pension adjustment (PA) will shed some light on the matter.

The pension adjustment

Our retirement savings system is designed to provide the opportunity for savers to set aside as much as 18% of annually earned income into one or more tax-sheltered plans: RRSPs, RPPs (whether MP or defined benefit(DB)), and deferred profit sharing plans (DPSPs).

To gather together the components of the comprehensive 18% limit, a pension credit system operates:

  • Straight dollar-for-dollar pension credit for contributions to MP RPPs and DPSPs,
  • A dollar-equivalent credit for benefits accrued under a DB RPP, based on the particular plan’s provisions

When accumulated, the total pension credits for a year form the PA, which is applied to reduce the maximum RRSP contribution room for the following year.  Of course RRSP room for a current year is based on earned income in the prior year.  Thus the PA dovetails the available information from the prior year into the current year’s RRSP room calculation.

Note that there is no pension credit calculation for contributions to group RRSPs, as this latter plan type simply shares the maximum RRSP room after the PA calculation.

… and PSPA, and PAR

The story doesn’t end with the PA alone.  There are two other components to the system that account for changes in RPP and/or DPSP plan benefits, and may affect RRSP room.

There may be changes to a DB RPP that improve the pension the member would be entitled to receive.  For example, there could be a negotiated increase to the per-year credit rate in calculating the eventual pension, say from 1% to 1.5%.  In light of the improved benefit, the pension member had been entitled to place more in RRSPs than should have been the case.  A past service pension adjustment (PSPA) sums up the pension credits that would have applied based on the upgraded benefits, and this then reduces RRSP room.

Just as the PSPA may reduce RRSP room, when someone terminates membership in a DB RPP or DPSP, there may be a loss of expected benefits.  A pension adjustment reversal (PAR) restores RRSP room that had been previously reduced based on that expected but now un-received benefit.

The full RRSP room calculation

Gathered together, the RRSP contribution limit for a year is:

+ Unused room at the end of the immediately preceding year

+ 18% of previous year’s earned income (subject to RRSP dollar limit

– Any PA

– Any PSPA

+ Any PAR

TABLE: Contribution limits since 2003

              RRSP       MP RPP   DB RPP       DPSP

2003        $14,500    $15,500    $1,722.22    $7,750

2004        $15,500    $16,500    $1,833.33    $8,250

2005        $16,500    $18,000    $2,000.00    $9,000

2006        $18,000    $19,000    $2,111.11    $9,500

2007        $19,000    $20,000    $2,222.22    $10,000

2008        $20,000    $21,000    $2,333.33    $10,500

2009        $21,000    $22,000    $2,444.44    $11,000

2010        $22,000    $22,450    $2,494.44    $11,225

2011        $22,450    $22,970    $2,552.22    $11,485

2012        $22,970    $23,820    $2,646.67    $11,910

2013        $23,820    $24,270    $2,696.67    $12,135

2014        $24,270    $24,930    $2,770.00    $12,465

2015        $24,930                     1/9 MP        1/2 MP

MP RPP = Money purchase registered pension plan (also know as a defined contribution registered pension plan),
DB RPP = defined benefit registered pension plan,
DPSP = deferred profit sharing plan

Interest on RRSP loans: Payback for the payoff

The concept of the RRSP loan is firmly ingrained in our collective retirement savings psyche.  Whether to enable a current year contribution or as a means of catching up on past unused room, the process can be a catalyst that spurs on the savings habit.

Still, it should be kept in mind that this cannot be a permanent arrangement, but rather a temporary time-shifting tool.  As with any loan, there must be a plan for how and when that loan will be retired.  After all, it’s not free money.  

And at the core of appreciating the value proposition is the need to have a clear understanding of how interest on an RRSP loan is treated.  

Interest not tax deductible

Where money is borrowed and put to an income-producing purpose, interest payments are generally tax deductible.  This general rule applies to non-registered accounts, and rests on the potential for dividend or interest income, both taxed annually as earned.  

On the other hand, where a loan is undertaken in order to make an RRSP contribution, interest is not deductible.  To some that may seem unfair, but there is a quid pro quo logic behind this treatment, in that income and growth within an RRSP are not subject to tax.  

Thus there is an element of symmetry in this comparison: deductibility with taxable income, non-deductibility with tax-exempt income.

Bear in mind though that for either account type, the eventual drawdown will be taxable.  That would mean one-half taxation on capital gains when cashing out a non-registered account, compared to full taxation of money coming out of a registered account.

The combination of non-deductible interest with eventual taxable income should serve as reinforcement to retire an RRSP loan in a timely manner.  How timely?  Well, let’s look a little closer at the cost of that non-deductible interest. 

Servicing RRSP loans

To pay this interest, one must earn income, pay tax, then pay the interest.  Allowing for provincial variations, someone at $50,000 income faces about a 33% marginal tax rate.  It therefore costs this person $1.50 in pre-tax income to pay a dollar of interest.  

As a counterpoint, RRSP loans are always available at very favourable rates, often only a percentage point above prime rate, or even less.  With prime at 3% in early 2013, the current range is about 3.5% to 6%.

Beneficial though that may be, remember that the principal will eventually need to be returned to the lender, in addition to interest payments in the meanwhile.  Just as the interest is not tax-deductible, neither is the principal repayment. 

Hopefully this casts things in fuller light, making it clear that the pre-tax cost of making the contribution is essentially 150% of the amount borrowed in our example.  

Payback timeline

This kind of analysis is what underlies the common recommendation to use one’s tax refund to reduce RRSP loan principal.  Absent a real emergency arising between the time of contribution and tax refund, this should be the first and only priority for that refund. 

Beyond that, the borrower should endeavour to retire the entire loan within the year.  In fact, if it can be retired sooner then the monthly cash flow earmarked for repayment can instead be allocated directly into deductible RRSP contributions, progressively weaning away from the need for RRSP loans as the years pass. 

On the other hand, if that loan remains outstanding beyond the year, it then affects the person’s capacity to make later RRSP contributions, with or without the assistance of RRSP loans.  

Overall, and guided by these principles, RRSP loans can indeed be helpful in encouraging savings. In particular, a better understanding of the interest component can push a person further along that savings path towards realizing retirement goals.