When "over"-over-contributing to an RRSP can make sense…?


This is an advanced level topic – keep reading to find out why… 

Piggy_Bank.jpgOne too many "over"’s? Well, first you have to be familiar with the lifetime $2000 over-contribution limit. As you are probably aware, when you make a contribution to your RRSP it qualifies as a tax deduction, but of course only when you are within your "contribution limits".

You may also be aware that there is a lifetime $2000 over-contribution limit which means you can exceed your contribution limit, but you won’t be able to deduct the contribution from your tax return. So while you won’t get a tax refund for that "over-contribution", many people will still suggest taking advantage of the over contribution limit as early as you can in order to take advantage of tax-free compounding on as much money as you can.

You may ALSO know that any balance you contribute over and above your allowed contribution (and $2000 over contribution) is subject to a hefty tax of 1% PER MONTH. Certainly a big deterrent to over-over-contributing.

But there does exist a specific situation when incurring that penalty may make good sense. But first we must review some tax semantics. Your RRSP contribution room is created based on your PREVIOUS year’s earned income. That means the first time you file a tax return showing an income, you will be able to contribute to your RRSP in the following tax year.

Let me make that clear: If you earn $50,000 in 2007, you will create $9,000 in RRSP room on January 1st, 2008. (You create RRSP contribution room based on 18% of your previous year’s income up to certain limits.)

So now back to when over-over-contributing may make sense: in the year you turn 71 (new age at which you can make contributions to an RRSP before winding it down) IF YOU ARE STILL WORKING you will still create contribution room for your RRSP and that room is created on January 1st of the year you turn 72.

So let’s take an example to see why this is important: Joe turned 71 in June this year (2010) and is working. He earns $100,000 this year and therefore will create $18,000 of RRSP room on January 1st, 2011. Since Joe is turning 71 in 2010, he need to wind-down his RRSP and he chooses to create a RRIF account. He has maxed his RRSP until now and has no more allowable room. He has even made the lifetime $2000 over contribution.

Joe can contribute $18,000 in an over-over-contribution in December of 2010. He will be over his allowable limit and will incur a 1%/month penalty on the over-over-contribution balance… for one month. This is because his newly created RRSP contribution room becomes "active" on January 1st, 2011. The only caveat is that you have to make the over-over-contribution BEFORE converting your account to a RRIF (which does not allow for contributions – only withdrawals).

So in other words, for the price of $180 in penalties, you can contribute (in this case) $18,000 more money into your tax sheltered retirement account!

Please note that you should consult with a Chartered Accountant or other tax professional before engaging in any tax strategies for your own situation. And for aggressive strategies like this, it probably wouldn’t hurt to get a second opinion or double check with the CRA yourself – they are easily accessible and very willing to answer your questions. "An ounce of prevention" as they say… :)

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Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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