Monday, February 11, 2008

RRSPs and tax withholding

As we near the February 29 RRSP deadline, lots of posts are popping up regarding RRSP contribution strategies. Million Dollar Journey has an interesting post that derives a formula for calculating an appropriate RRSP loan amount. He recommends a target loan amount that is equal to (or less than) the total tax refund that would result. This means that, once you receive your tax refund, you can immediately pay off your loan in full.

The nice thing about this approach is that it essentially allows you, if you have the contribution room, to use your 2007 tax refund as a 2007 RRSP contribution. In his example, where you already have $5,000 in 2007 contributions, with a 40% marginal rate, you will be expecting a $2,000 tax refund. By taking out a $3,333 loan, and using it to make a $3,333 contribution before February 29, your total tax refund will increase to $3,333 (the amount of the loan). You therefore have no new debt (since the refund and the loan cancel each other out), and you have $2,000 in new retirement savings (from contributing your original 2007 refund) plus an additional $1,333 that basically came out of "thin air". Best of all, this is a trick that you can repeat year after year. Leveraged investing at its best.

My employer has a less-than-intuitive approach to income tax withholding, mostly with respect to our year-end bonus. Any bonus for which we qualify is included in the first pay of the new year, rather than the last pay of the year. We have the option to defer up to 85% of the bonus into a group RRSP, and I've taken advantage of this option each of the past three years. This has an unexpected (at least to me) impact on tax withholding.

Take this year, for example. I deferred my bonus with a $6,000 RRSP contribution on January 10. This will be claimed as a deduction on my 2007 tax return, but my employer adjusts my tax withholding as if it were a 2008 deduction. Therefore, every year I need to match my previous year's contribution in order to avoid paying taxes (failing to do this last year landed me with a $1,400 tax bill).

It took me a while to wrap my head around this one, but now that I'm aware of it, it forms a crucial part of my RRSP contribution planning.

What are your RRSP or other tax planning tricks?

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