The registered retirement savings plan (RRSP) deadline is just two weeks away, so you may want to double check your contribution limit for 2021 to help determine whether you want to sock some more money away before March 1.
To assist you, here’s a refresher on RRSP deduction limits, some tools you can use to help you calculate your potential 2021 tax savings, and a cautionary tale from the court where a taxpayer made a costly mistake when contributing to his RRSP based on a misunderstanding of his contribution limit.
Your limit for 2021 begins with your RRSP deduction limit from 2020, since unused room is automatically carried forward from year to year. Then, any RRSP contributions you deducted on your 2020 return are subtracted, before adding your new contribution room for 2021, equal to 18 per cent of 2020 “earned income,” to a maximum of $27,830. Earned income includes (self-)employment income and rental income, among a few other things.
The 18-per-cent limitation is tied into something called the “factor of nine,” which uses a hypothetical defined-benefit pension plan in which saving nine per cent of an employee’s annual earnings will let an individual buy a retirement annuity equal to one per cent of pre-retirement income. The Tax Act lets a member of a defined-benefit pension plan accrue a maximum tax-free annuity of two per cent of final earnings in the year of accrual, which, over a 35-year working career, would provide a pension equal to 70 per cent of pre-retirement earnings.
If you were a member of a pension plan, you may have a 2020 pension adjustment deducted (you can’t double up on total savings) before arriving at your 2021 RRSP deduction limit. But that’s not necessarily how much you can contribute, because, in some cases, you may have chosen not to deduct previous RRSP contributions in a prior year. For example, if you contributed to an RRSP in 2020 while you were on a parental leave and had little income, you may have decided to defer taking the deduction until a future year. In these situations, the undeducted contributions reduce the amount you can contribute for 2021.
You can find your RRSP deduction limit by visiting Canada Revenue Agency’s My Account service online or by checking the RRSP Deduction Limit Statement on your most recent notice of (re)assessment.
There are a variety of online tools available to help you decide how much to contribute. Intuit Inc.’s TurboTax offers an RRSP optimizer that shows how much your tax refund could increase (or tax owing decrease) by making an RRSP contribution. Enter your income, tax paid to date, and province and residence, and a slider allows you to play around with your RRSP contribution amount as your refund (or liability) grows or shrinks. Accounting firm EY also has an RRSP calculator that will show what your RRSP contribution is worth in all 10 provinces and territories, based on your level of taxable income.
But, no matter how much you decide to contribute this RRSP season, it’s important to stay within your contribution limit or face a penalty tax of one per cent per month for each dollar you overcontribute (beyond a $2,000 permitted overage). A recent tax case decided last month involved a taxpayer who was hit with the penalty tax for a mistaken RRSP overcontribution that stemmed from his misunderstanding of what constituted “earned income.”
In 2013, the taxpayer lost his job after 12 years of service with his employer. He was unhappy with how he had been terminated and retained a lawyer. With the help of his counsel, the taxpayer negotiated a severance payment of approximately $165,000. He received this amount in 2014 and included it in his taxable income. During the 2015 RRSP season, specifically, in February of that year, the taxpayer made an RRSP contribution of $24,270.
Fast forward three years to March 2018, and the CRA assessed the taxpayer an RRSP overcontribution penalty tax of $1,106 in respect of the 2015 taxation year. The penalty tax was on just part of his RRSP contribution, since he did have some contribution room available.
The issue in the case came down to whether the payment from his former employer fell within the definition of earned income for the purpose of calculating his available room. If it did, there would not have been an overcontribution.
The taxpayer maintained the payment formed part of his remuneration from employment. After all, he would not have received the amount had he not been previously employed by the payor. Indeed, if the payment in issue was not remuneration and not earned income, then, he argued, he should not have been taxed on the payment at all.
That may have been true before 1981, as prior jurisprudence concluded that such payments were not considered employment income. But, in late 1981, the definition of a “retiring allowance” was amended to include the full amount of any payment to an employee received as damages, or pursuant to a judicial determination. Under the current wording, a retiring allowance is defined as an amount “received on or after retirement of a taxpayer from an … employment in recognition of the taxpayer’s long service, or in respect of a loss of an office or employment of a taxpayer, whether or not received as, on account or in lieu of payment of, damages or pursuant to an order or judgment of a competent tribunal.”
Retiring allowances, however, are taxable as “other income,” not as employment income, and are therefore excluded from the calculation of earned income that establishes RRSP room. As a result, the taxpayer lost his case and was stuck with the overcontribution penalty tax, which the judge did reduce somewhat due to a computational error by the CRA.