Lump sum cash receipts and the RRSP

It is a great day when you receive a large sum of money. Perhaps you just sold a business; maybe you received an inheritance from your parents; it could be an award settlement from a legal claim; possibly a divorce settlement; or, maybe even a lottery winning. And for most Canadians, it’s not unusual to have lots of room to deposit a large sum to their RRSP.

A quick refresher on the benefits of an RRSP is in order.

First, there is the immediate income tax savings. However, I like to remind my clients that this income tax savings is like a loan from the government, and much of it, if not all, will need to be repaid when the money is withdrawn from the RRSP.

Second, there is the absolute income tax savings available if you are in a higher tax bracket when you claim the deduction then when the money is withdrawn. The savings can happen in two ways: your own tax bracket decreases, or you use a spousal RRSP and your retired spouse will be in a lower tax bracket.

Third, you benefit from the additional growth of the tax-free compounding.

Fourth, for individuals without eligible pension income, an RRSP can be converted to an RRIF at age 65 to access the pension credit. And, there are other benefits as well, depending on individual circumstances.

Before making a large RRSP deposit, your clients need to stop and carefully review their tax situation. First, one must remember that many large cash receipts may not be taxable, such as an inheritance or lottery winning. Therefore, one must look at other sources of income to determine whether there will be any savings by making a contribution.

In some cases, there are reasons for not making a contribution at all. For example, the sale of a business may give rise to alternative minimum taxes when the enhanced capital gains exemption is used. A taxpayer has seven years to obtain a refund of these minimum taxes, and will require a certain amount of taxable income for this recovery. Depending on income sources and ages, these minimum taxes may never be recovered, and, in such situations, an RRSP would provide no tax benefit.

Remember, an RRSP contribution made this year need not be deducted this year. Excess contributions, as long as they do not exceed the contribution limit, may be carried forward indefinitely and deducted in a future year. Do not make the mistake of claiming too much of a deduction in one year, which can happen inadvertently using some tax preparation software. I have seen RRSP contributions claimed when there was no taxable income! What a waste.

Normally, reducing taxable income to the top end of the lowest bracket is as far as you will want to go. However, in situations where someone wants to eliminate taxes, then you need to decide whether to eliminate federal, provincial or both taxes, since one will be eradicated before the other.

If there will be a benefit from the RRSP deduction in a future year, but none this year, it makes sense to deposit the money now to start the tax-free growth and income tax deferral process. Then, claim the RRSP deduction on a year-by-year basis to reduce future income levels to a lower bracket. However, if a client will be paying 25% tax in retirement, it likely provides little benefit to eliminate taxes at 25% today.

If a client is already in a low tax bracket, or if future benefits are doubtful, particularly if the tax bracket is not expected to reduce, using a Tax Free Savings Account (TFSA) would likely be of greater benefit. Receiving tax-free income is always better than receiving taxable income, and, certainly, if a lump sum of cash is received, it is likely possible to do both a TFSA and an RRSP.

In addition Registered Education Savings Plans provide an excellent way for parents and grandparents to save for their children and grandchildren’s education, while also encouraging post secondary education. I think many investors and advisors overlook the long-term benefits of an RESP because the RRSP provides short-term gains while the RESP does not provide results until the child goes into post-secondary education. However, I encourage you to look at not only the tax savings from an RESP but the psychological encouragement to children to continue their education and yield substantial benefits by way of higher salaries and secure employment for the rest of their lives.