bout de papier, Vol. 8, No. 3 (1991) — Summer 1991 // Été 1991, pp. 34–35
As a result of changes to the Registered Retirement Savings Plan (RRSP) legislation on 1 January 1991, all foreign service officers may now make a deductible contribution of at least $1,000 a year to an RRSP. Those who earned between $28,900 and $86,111 in 1990 may make a deductible contribution of up to $2,821 in 1991. These contributions are in addition to the mandatory deductions for superannuation that all federal government employees make. This is welcome news for those who earned more than $46,667 in 1990. In that year, they contributed at least $3,500 in superannuation, which meant that they could not make any deductible contributions to an RRSP.
Under the new system, the 1991 limit for deductible contributions to your RRSP is calculated by subtracting a “Pension Adjustment” (PA) from the lesser of 18% of your 1990 earned income or $11,500. (Note these important changes: the fraction of earned income has decreased from 20% to 18%; the ceiling has increased from $3,500 for members of registered pension plans to $11,500; and contributions are now based upon your prior year’s income, not the current year.) Earned income includes salary, rental income, maintenance receipts and net business income, but does not include investment income (interest and dividends), pension receipts and retiring allowances. Maintenance payments for which you claim a deduction reduce your earned income. The maximum contribution of $11,500 for 1991 will increase by $1,000 per year to $15,500 in 1995, after which it will be indexed in accordance with increases in the average industrial wage. This means that the earned income necessary to make the maximum contribution will increase from $63,889 for 1991 to $86,111 for 1995.
The PA is a new concept. It is a dollar figure that measures the “imputed value” that an employee received in the previous year from being a member of a registered pension plan. For those who are members of “money purchase” pension plans, the PA is simply the sum of the required contributions made to the plan during the year by the employee and the employer. For those who are members of “defined benefit” pension plans, which includes all federal government employees, the PA reflects the benefits that accrue under the plan during the year.
34 bout de papier Vol. actual contributions made to the plan by the employee and the employer, however, are not used in calculating the PA.
For federal government employees, benefits under the pension plan accrue at a rate of 1.3% on earnings under $28,900 and 2% on earnings above that amount. Because of the five year phase-in already referred to, 1990 earnings in the range starting at $63,889 and ending at $86,111 are not used in the calculation. To calculate your PA, multiply your annual income by the accrual rate, multiply that product by 9, and then subtract a $1,000 offset. Here are two specific examples involving federal government employees with 1990 earnings of $50,000 and $90,000.
• PA on earnings of $50,000: [(1.3% × $28,900) + 2% ($50,000 – $28,900)] × 9- $1,000 = $6,179
• PA on earnings of $90,000: [(1.3% × $28,900) + 2% ($63,889 – $28,900)
2% ($90,000 – $86,111)]
×9- $1,000 = $9,379
For these employees to determine the amount of deductible contributions they may make to an RRSP in 1991 (commonly referred to as “contribution room”), they must now subtract their PA from the lesser of 18% of their 1990 earned income (assume that salary is the only component) or $11,500. For the $50,000 employee, 18% of $50,000 is $9,000, which is less than $11,500. The contribution room is therefore $9,000 minus $6,179, which is $2,821. For the $90,000 employee, 18% of $90,000 is $16,200, which is more than $11,500. The contribution room is therefore $11,500 minus $9,379, which is $2,121. Contribution room declines quickly at earned income above $86,111. The $1,000 offset is reached at earned income of $96,226, so the contribution room for employees earning above that amount is the $1,000 minimum.
If this sounds complicated, do not despair. Your employer is responsible for calculating the PA, and it appears in Box 52 of your 14 slip. Also, based on your income tax return, Revenue Canada will send you a statement confirming your RRSP contribution room in the fall.
However, it is better to know your annual contribution room early in the calendar year. This enables you to make your RRSP contribution earlier, and take advantage of the tax-sheltered compounding over a longer period. This will yield a larger sum on retirement. It also allows you to estimate the monthly equivalent, which can be used to purchase mutual fund shares and gain the benefit of dollar cost averaging. For example, those with earned income between $28,900 and $86,111 who contribute $235 per month would make full use of their $2,821 contribution room.
There were two other important changes to the legislation: one dealing with over-contributions, and the other dealing with carry forwards.
It is now possible for those over the age of eighteen to over-contribute without penalty to an RRSP to a cumulative maximum of $8,000. If you over-contribute in one year, you may claim the tax deduction in subsequent years as more contribution room becomes available. Alternatively, you may allow the over-contribution to compound and earn tax-sheltered investment income, and then continue to contribute to the extent of your contribution room each year. If you adopt this alternative, you will not get a tax deduction for the over-contribution and, like any amount that is received from an RRSP, the over-contribution will be taxable when it is withdrawn. This is a form of double taxation but, if the over-contribution is left in the RRSP for about 15 years, the positive effect of tax-sheltered compounding will outweigh the negative effect of double taxation.
Another helpful change is the ability to carry forward unused contribution room for up to seven years. This means that if heavy expenses for a house or university tuition make you unable to contribute to an RRSP in a given year, you may make up the contribution over the next seven years. However, by doing so, you delay the receipt of the tax deduction on the contribution, and decrease the length of time that the tax-sheltered compounding is working in your favour. Therefore it is advisable to resort to the carry forward only where absolutely necessary.
There is no question that an RRSP is one of the best investments available. Where else does one receive a tax deduction for making an investment, and have the effect of tax-sheltered compounding throughout the life of the investment? The name of the game is definitely to contribute as much money as possible to an RRSP, and to do so as early as possible. With the changes to the legislation, it is now never too early nor too late to take advantage of this excellent tax deferral technique.
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Originally published in bout de papier, Vol. 8, No. 3 (1991) — Summer 1991 // Été 1991, pp. 34–35. Read the rest of this issue →
