Blessed by the Potato

Inspired by recent real-life events¹, let’s talk about what happens if you accidentally over-contribute to your RRSP.

Unlike for the TFSA, the government does track your RRSP contributions closely and will update you each year. Good thing too — RRSP contribution room accumulation is a good deal more complicated than asking how old you are and looking at your own activity, like with the TFSA’s across-the-board $5500 per year. Simply check the bottom of your notice of assessment for your contribution room for the year.

Your financial services providers will send you receipts to summarize your RRSP contributions at the end of the year, which makes it easy to report these on your taxes (which you do have to do).

There are penalties for over-contributing, but you get $2000 of leeway, so if you over-contribute by just a little bit you can carry it forward to use in a future year, without a penalty. If you over-contribute by more than $2000 there will be penalties, and you’ll want to pull it back out as soon as possible — though on that last point most people don’t find out about their over-contribution mistakes until the next tax year (at tax time in the spring), by which time they’ve earned enough new room to absorb them, so withdrawing to stop accruing penalties is often not necessary in practice².

When you do have an over-contribution, you can only claim a deduction up to your available room, but you have to report all of the contributions — the difference will get carried forward. Do not edit the amounts on your RRSP contribution receipts to keep your reported contribution below your deduction limit.

In most (all?) tax software, if you enter contributions above your deduction limit, the excess will automatically be carried forward, so you may not need the previous instructions for dealing with Schedule 7, but be sure to have a look at your Schedule 7 to be sure.

If you’ve over-contributed beyond the leeway room, then you’ll be facing a 1% tax per month — and this form (T1-OVP) is where you calculate and report it.

1. The sad thing is, there’s going to be more than one RL friend saying “hey, this one’s about me!”
2. Be sure to check your own situation and take care of over-contributions as soon as possible if you’re over the $2000 allowance.

In the last post we talked about how to defer your deduction, but glossed over when that would make sense. A reader pointed out that there are actually few¹ cases where it makes sense to do so.

The base case is where you have some money and are in a low tax bracket now, but will be in a higher one soon. I had suggested that this was where it would make sense to contribute immediately but defer the deduction, so as to avoid ongoing taxation of the funds if you simply waited to contribute. But this reader encourages us to look at those cases more closely.

Let’s say your money grows at 5%, and you get taxed on half the growth (like capital gains), and you start in the 20% tax bracket, and move to the 35% bracket the next year. If you contribute $100 to your RRSP and hold off to take the deduction, then you’d have:
Start in RRSP: $100
Refund from taking deduction at 35% bracket: $35
Tax-free growth in RRSP over year: $5
Total: $105 in RRSP, $35 outside, total of $140

If you contribute and take the deduction immediately, you’d have:
Start in RRSP: $100, initial refund: $20. Put that in the RRSP, but then assume the refund from that comes the year after (at the 35% rate).
Total after the year: $126 in RRSP, $7 outside, total of $133.

If you wait to contribute, your $100 grows to $105, but then if you have to pay tax at 35% on half the growth (the gain is realized as you contribute) you’d only have $104.12 to contribute. But that extra contribution would bring you a slightly larger refund.
Total: $104.12 in RRSP, $36.44 outside, total of $141.14.

It’s tough to compare these outcomes because they’re not all in the same place — money in the RRSP is subject to taxes on withdrawal. So we can contribute a bit more to make the sheltered amount equal and the comparison easier: for the last scenario, $105 in RRSP, $35.88 outside by contributing $0.88 and getting $0.31 back. So, a slight benefit to just paying the taxes and contributing the larger amount when you’re in the higher tax bracket — which you’ll have to weigh against the need to track and report the non-registered investments for taxes.

This is all assuming that you have the contribution room to contribute more later. However, RRSP contribution room is finite, and can be quite limited if you’re in the situation of having lower employment income (e.g., a grad student on scholarship) and plenty of non-registered investments. RRSP contribution room carries forward, but it does not grow or get inflation adjustments. So in the case where you can only contribute $100 no matter which point in your life that is, would it make sense to contribute right away and then defer taking the deduction? Again, the comparison gets tricky because we’ll have different amounts inside and outside the RRSP, so it’s hard to compare head-to-head. If you figure that the RRSP is money good (you’ll be able to pull it out completely tax-free) then the contribute immediately and defer the deduction plan wins; it looks like the break-even is where the rate on RRSP withdrawals is the same on the rate applied to the non-registered investments.

Reality is a bit messier because you wouldn’t be immediately pulling the RRSP money out again, you’re hoping for it to keep compounding into the future. Using your room as soon as possible and deferring the contribution gets you more in the shelter, versus having more in your non-registered account to face the drag of taxes over time. I haven’t figured out the math to get an analytical formula, but from playing with a spreadsheet it does look like it does generally make sense to contribute and defer the deduction if your room is finite and your tax drag is about a quarter to a third of your marginal rate (which is the case, even for dividends, for people with incomes over ~$45k).

Ok, that was a bit confusing and not especially conclusive. There are cases where it makes sense to contribute and defer taking the deduction, mostly when your contribution room is limited (where you’ll end up with non-registered investments no matter what), but it’s not as hands-down beneficial as I thought when I did it as a grad student, and not as simple as I implied in the previous post looking only at the value of the deduction (and ignoring that the contribution will likely grow over time even if left in a taxable account). If you’re not worried about running out of RRSP room (with employment income without a pension adjustment, and with a TFSA, it’s hard to run out of tax shelter for many people), then the contribute-but-defer plan is likely not for you.

Still, the previous post on knowing how to defer is still useful because we don’t have perfect knowledge of the future. There are situations where you may contribute in a lower tax bracket and want to defer taking the deduction, and that’s when you contribute without knowing what your tax rate for the year will be in advance. For instance, if you make regular contributions in the first half of the year, but then find yourself unemployed in the last half, you may wish to defer taking the deduction for those contributions until you’re back up to speed; or where you work one job and make contributions but then get a big raise towards the end of the year or early in the next. Yes, it may have been even better to hold off on making the contributions in the first place, but that would have required an impossible ability to predict the future.

1. Actually the word used was “never”.

Putting money into your tax-sheltered accounts (RRSP, TFSA) is great: not only are the gains on your investments not taxed, tracking the gains and distributions becomes totally optional because the CRA does it for you (or more properly doesn’t care, and treats it like a black box where only what goes in and comes out matters).

While using your TFSA right away can be a good move for almost everyone, the RRSP can be trickier: if you’re young and not making much now, you may want to wait until you are closer to your peak earnings (or at least a few tax brackets higher) before you start contributing and taking the deductions. You can of course hold on to your contribution room — it will carry forward until you’re ready to use it.

However, a neat feature is that the contribution and taking the deduction are separate steps: you can contribute to your RRSP to get tax-free compounding and a freedom from paperwork and hold on to the tax deduction until a higher-income year. I did this towards the end of grad school, maxing out my meager RRSP room while deferring the deduction until last year when I was working full time. Indeed, this is one of the classic examples of where such a move is the way to go. Another case where you may want to defer taking your deduction is when you have a new job or big raise that starts partway through the year, and won’t hit that next tax bracket until the year after.

When should you consider deferring the deduction? [edit: please see the next post for when deferring might make sense.] I don’t have a precise formula or spreadsheet ready for you. You do need to consider the time value of money: a tax deduction (refund) now will be more valuable than one a few years from now. There should be a reasonable chance of getting to a higher bracket soon — and the bigger the projected shift the more you may be willing to wait. Waiting 3-4 years to move from a 20% tax bracket to a 31% one was a no-brainer for me — the tax refund was worth 50% more in just a few years. Deferring for a decade in the hope you’ll move from 31% to 33% or 35% may not make sense for you. If you still have TFSA room, use that first — you can always pull from your TFSA to contribute to an RRSP later. But if your TFSA is full and you’re starting to build non-registered investments while you wait for your salary to increase to use your RRSP room, then contributing and deferring may make sense.

I’ll just note that some cases make sense for deferral (like mine in grad school), but for many people out there in the middle class, the climb through the tax brackets is gradual enough that it usually will not make sense to defer taking the deductions — if you’re not sure, you’re probably one of the many who will be just as well off taking the deduction immediately.

How do you engage in this magical deferral? The contribution step is the same as always: move money into your RRSP (and once it’s in there, invest in something). You’ll get a contribution receipt, which you will report on your taxes — even if you plan to defer taking the deduction you must report the contribution, and you must have enough RRSP contribution room for it. Your tax software will likely then try to automatically use all of your contributions for deductions right away to maximize your current refund. If instead you want to defer them, search for a form called Schedule 7. If you follow along in the PDF/paper version of the form, it’s divided into parts:

Part A — Contributions
Part B — Repayments under the HBP and the LLP
Part C — RRSP/PRPP deduction
Part D — RRSP/PRPP unused contributions available to carry forward

Part C is where the magic happens: you just tell the CRA how much of your contributions you want to use for a deduction this year. If you contributed $5000, but want to carry-forward that whole amount, just override line 13 with $0 (you want to use none now). Or you can enter a partial amount if you want to use some now and some later (useful if you’re just over a marginal tax bracket break).

To do this in TurboTax, click on the forms button at the bottom of the screen, and then the “form lookup” option. Start typing “schedule 7” and you’ll see it pop up. Once you open it, it will look almost identical to the CRA form above. If you try to change line 13, it will take you to a special TurboTax “worksheet” where you can enter the amount you want to carry-forward, which saves you a step of subtraction. Note that you can also go directly to the worksheet from form lookup (just look for “RRSP”), but it makes more sense to me to look for schedule 7 than some special TurboTax thing.

In StudioTax, you can adjust this right from the initial wizard when you’re entering your RRSP contribution information: uncheck the “maximize RRSP claim” option. I’m a little less familiar with Studiotax, but it appears that if you want to defer your deduction after you’re past this wizard step, you have to click on “forms” at the top to ensure Schedule 7 is in the “added forms” category, then click on “federal forms” at the bottom of the screen. Double-clicking on line 13 will bring the wizard screen below back up so you can adjust how much you want to claim this year.

Once you’ve deferred your deduction, you’ll see it show up on your notice of assessment. If you use the same tax software year to year, it will pull that deferral forward for you next year; if not, you’ll have to enter it from your notice of assessment, and you’ll see it show up in the very first line of Schedule 7 as unused RRSP contributions. Every year your tax software will try to automatically use your deferred contributions and any new contributions for you, so if you’re trying to defer for more than a year then you’ll have to make the adjustment to line 13 each year until you’re ready to take it.

“I love deadlines. I love the whooshing noise they make as they fly by.”

February is usually better known as “RRSP season” as the deadline approaches — this year that deadline is March 2, 2015.

But a deadline for what, exactly?

The deadline for RRSP contributions to count against the previous years’ taxes — due to a quirk in the rules, contributions made the first 60(ish) days of the the year can count to the current year or the previous one — so this is a last chance to make a contribution and reduce your 2014 taxes owing.

Yes, there is time value to money, and you don’t want to go a lifetime without contributing to your RRSP, but this is the least important deadline there is. If you don’t log in to your online banking to make a contribution until March 3rd this year, it just means you have to wait a year and two months for your refund instead of just two months. When you’re 75 and spending that money you’ll care whether it’s there at all far more than whether the tax deduction was taken a year later. Plus for many people, the TFSA is a better choice to prioritize anyway, so this RRSP and refund stuff is just noise. Oh, and implicit there is another fact about the deadline: you can contribute at any point during the year, not just during this special “RRSP season.”

But no, you will not lose your contribution room — you carry it forward and accumulate it until you’re ready for it. The consequences of missing the deadline are very minor, so if you’ve procrastinated this long on putting together a financial plan and starting to invest, another few weeks or months is not going to kill you — though please do commit to getting it done sometime this year.

Indeed, you don’t have to contribute in a lump sum right at the end and can ignore the deadline by starting a regular contribution plan now, and even fill out a form get your employer to stop taking the tax off at the source so you get the money working for you right away (and then you don’t get a refund in the spring — which also takes away the temptation to spend it). So despite the media and advertising blitz that happens every February, RRSP “season” isn’t really a big deal.

So, let’s not stress out over this deadline: if you miss it, the consequences are pretty minor. The last few weeks of February are the worst time to try to go to a bank to open an account or meet with your planner. But if you do want to get your contribution in before the deadline you can do so and let it sit in cash (or a money market fund — the equivalent for a mutual funds account), as Sandi points out in this post, and make a plan at your leisure, and invest it when you’re more prepared (though seriously, it only takes one weekend to burn through the Value of Simple).

Sandi asked me for some thoughts on budgeting and methods to control or track spending for a recent Because Money episode, and right now I’m staring at over a year’s worth of receipts that I just can’t seem to find the time to go through, so it’s probably a good time to talk about the history and evolution of my budgeting process.

When I was a grad student things were tight and budgeting and frugality really mattered. My entertainment budget was often around $30/mo, which is really easy to blow through if you forgot about the movie you went to see three weeks ago or go out with friends a lot. But I’m really bad at the forward-planning money-in-jars kind of restrictive budgeting — I’m much better about adapting to fit the total budget than hitting it on every category. Though that said, I was just bouncing back a few years in my calendar for something else, and saw where I had mapped out which days I could treat myself to pizza so I was paying some attention to my category limits.

So my method was to gather up all my receipts¹ and bills every month and lay them all out on a piece of paper (and eventually, a spreadsheet). I’d group them: food, rent, eating out, entertainment, car, utilities, other. Then all the receipts would be stapled to a piece of paper and filed away (in case I needed more detail than the summary). I started by just tracking things — I came in fairly frugal even from living with my parents — which also helped give me an idea of the irregular expenses that I had to try to amortize. After a while I saw where I needed to put in some more effort, and just made a vague effort to do better. I know, this is the dieting version of “I just eat whatever I want and never feel hungry and end up naturally thin” but there you have it. It didn’t take too long before I came in on-budget most of the time. I never stressed too much about big expenses in one month or another, like car repairs or blowing entertainment out of the water in October and December, or having the categories come out different than I planned: as long as it all averaged out over the year.

Once I had those unconscious frugality muscles built up and a fairly natural sense of my set-point, I started to slack off on the budgeting process. It went from being a monthly ritual done as soon as possible after the month end, looking at each line item on each receipt, to a quarterly and then semi-annual check-up and review process. I found that the medium-length time periods were better for smoothing out the month-to-month noise, but it was still a task I could do in a reasonable amount of time. Pushing out to semi-annual just encouraged more and more procrastination.

After Blueberry was born I only did two more budgets, and now find myself with this massive pile of receipts and notes to go through. And it’s really hard to find the time. I thought I’d get around to it over Potatomas break, with two full weeks off and no natural disasters forcing an evacuation this year. But I didn’t — I just have so much to do now, and it’s really hard to prioritize a budget review because I know that I’m doing more-or-less all right: I’m sending the right amount of money from my chequing account to my investment accounts and Blueberry’s RESP to hit my savings goals, so however it’s happening, it’s all working out.

I know that my savings rate gives me a bit of a cushion to be sloppy with my budgeting — if I slip I might miss out on a year of savings, which would suck, but if something unexpected comes up or I spend over budget I’m not going to be instantly facing credit card debt or the poor house. But I’d still like to know how I’m spending my money, and going through my budgets does give me a nice picture of my personal inflation rate. So I’m thinking I’ll toss most of those old receipts and instead sample my budget for just a month or two to double-check that I’m on track, then go back into unconscious frugality mode again.

In terms of this kind of review-and-try-harder process, I should note that I was naturally frugal before starting my budgeting adventure, and just needed to tweak things a bit. Then once I found my stride, it’s been fairly effortless to stick to it. For many people out there a more rigid budget (with jars or the digital equivalent) might work better, as might be paying yourself first on every paycheque to save (I do not save evenly through the year — most of my contributions to long-term investments are in the front half, and Oct/Nov/Dec are usually negative, drawing down a chequing/savings account balance built up a bit in Jul/Aug/Sep).

So to try to sum up: what works for me is to not stress about it, and just try to be generally balanced and frugal, without focusing on any particular expense. Though my income is now pretty smooth (depending on freelance and consulting jobs), my spending is not, so I look out at the annual averages. If I ever get too sloppy though, that’s going to take a long time to spot and correct the problem.

1. I make notes for some purchases without receipts, and estimate others like “~$20 at Tim Horton’s over the last month.”