Carry-forward strategies

Until 1991, if you didn’t take advantage of your full RRSP deduction limit every year, it was gone forever. Use it or lose it was the rule. It was a tough rule, one that put many people at a disadvantage when it came to retirement planning. Predictably, they were often those who could least afford it: lower-income earners, younger couples strapped for cash, the unemployed, and families coping with a temporary financial crisis.As well, the restriction gave employees with a pension plan a big edge over those without one. Pension plan members could make past service contributions to increase their number of years of pension eligibility. Non-plan workers had no such option.

So when the entire retirement savings system was being reviewed in Ottawa during the 1980s, it was decided to build some additional flexibility into RRSPs by allowing unused deduction room to be carried forward. An explanatory document issued by the federal Department of Finance in 1989 put forward this rationale:

“This measure will be of particular benefit to individuals with fluctuating incomes as well as individuals who may find it difficult to contribute in a particular year because they e saving for a house, for example, or are starting a small business. This important innovation will thus enable all taxpayers to vary the pattern of their retirement saving to more closely fit their financial needs.”

The carry-forward mechanism officially came into effect on January 1, 1991. Under the regulations, any unused RRSP deduction room since the 1991 tax year could be carried forward and used at some future time. Originally, there was a seven-year time frame for unlimited use of a carry-forward credit, after which your ability to claim unused deductions would be governed by a special formula. However, Finance Minister Paul Martin removed this restriction in his 1996 budget, allowing carry-forward credits to be available indefinitely.

Your unused deduction room is basically your maximum allowable RRSP contribution for the year, less the amount you actually contributed and claimed on your tax return. (Technically, the possibility of making overcontributions to your plan also gives rise to unused deduction room, but the concept and strategy are quite different. You’ll find a detailed explanation in the section titled Overcontributions).

Suppose, for example, you were allowed to claim an RRSP deduction of $5,000 for the 2000 tax year. In fact, you only contributed $3,000. Under the rules, you may carry forward the $2,000 in unused deduction room to the 2001 tax year. If your normal RRSP limit for 2001 is $5,500, you may actually contribute $7,500 to your plan ($5,500 plus the $2,000 carried forward) and claim a deduction for the full amount. (Remember, no carry-forward is permitted for any tax years before 1991).

Sounds great. And, in certain circumstances, this rule is a big help for people who want to increase their RRSP savings. Here are some of the ways to take advantage of it:

Make up contributions missed because of lack of cash. There are all kinds of reasons for not making a full RRSP contribution, some good, some not. The early 1990s were difficult years for the economy. Many people found themselves short of cash, or even out of work. But even those who were unemployed for a period may have had a large RRSP deduction limit if they worked the year before, because the calculation is now based on the previous year’s earned income. The carry-forward makes it possible to use future earnings to make up for a cash shortfall because of unemployment. However, the unused contribution room should be used as quickly as possible.

Delay contributing until you’re in a higher tax bracket. RRSP contributions are treated as tax deductions, not credits. That means the higher your tax bracket, the greater the refund your contribution will generate (or, if you like, the more the government will subsidize your retirement savings). So it may make sense in some situations to use the carry-forward to defer your contributions to a year when you=ll be in a higher tax bracket.

Let’s take the case of a university student. She worked at a summer job in 1999 and part-time during the school year. Her total earned income for the year was $10,000. Her 2000 RRSP contribution limit was therefore $1,800 ($10,000 x 18%).

In 2000, she received her degree. On September 1, after taking a well-earned summer off, she began a full-time job, at an annual salary of $27,000. Since she started work late in the year, her income from the job in 2000 was only $9,000. Her personal, tuition and education tax credits reduced her tax payable to zero.

If she wishes, she can carry forward the unused $1,800 to the 2001 tax year, when she’ll be employed full-time. The result: a tax break worth about $500, when both federal and provincial taxes are taken into account.

This strategy will work for anyone who has up and down income years (e.g. commission salespeople) or who experiences a temporary drop in income (e.g. unemployment).

However, there is a better way to achieve the same tax planning result while increasing the value of your RRSP. You don’t have to claim a tax deduction in the year you make your contribution. If it is in your interest, you can put off making the claim until you are in a higher tax bracket. The difference between employing this strategy and using the carry-forward is that, in this case, the money goes into your RRSP immediately and begins its tax-sheltered growth without delay.

The downside to the carry-forward is that many Canadians are tempted to use it as an excuse not to make an RRSP contribution, arguing they’ll do it next year. Next year, unfortunately, never comes — they’ll just keep accumulating unused credits and never contributing to their retirement plan. In this case, the carry-forward becomes a rationale for procrastination.

There are three major disadvantages to allowing this to happen:

You’ll build up deduction room you can never use. Even if your income is relatively low, it won’t take long to build a large bank of carry-forward credits that you may never be able to use. Suppose, for example, your earned income in 2000 was $30,000, and it increases at 5 percent a year until 2006. You have no pension plan.

Your 2001 RRSP deduction limit is $5,400 (18% x $30,000). You decide you’d rather spend the money on a holiday in Florida. You’ll make it up next year, you promise yourself. But then something else comes up and you put it off again. This goes on for the next seven years. Here’s what happens:

Year Deduction Carried Forward

2001 $ 5,400

2002 11,070

2003 17,024

2004 23,275

2005 29,839

2006 36,731

2007 43,968

The danger is obvious. By 2007, you’ll have built up almost $44,000 in unused RRSP deduction room. But your annual salary at that point is just over $40,000. In other words, your unused deduction limit exceeds what you earn in a full year! How likely is it you will ever be in a position to make up for all those missed contributions?

You’ll lose your tax refund for the current year. You should always take your tax breaks when you can. There’s no way of knowing what a future government will do. For example, while RRSP contributions are currently treated as tax deductions, that may not always be the case. A future government may decide to convert them to credits, which will have the effect of reducing the refund they generate for everyone but those in the lowest tax bracket.

That could make the cost of delaying very expensive. For example, an Ontario resident in the top tax bracket in 2000 will recover about $0.48 of every dollar contributed to an RRSP in the form of a tax refund. However, if that person used the carry-forward and the rules were then changed to implement a tax credit system, the refund generated would only be worth about $0.27 for each dollar contributed.

Using the carry-forward reduces the end value of your RRSP. The magic of tax-sheltered compounding is the reason it’s possible to build a large reserve of RRSP funds over time. The longer the money grows in your plan tax-free, the greater the end value will be. Using the carry-forward compromises this advantage by reducing the number of years of tax-sheltered compounding available to you. Even the loss of a few years can make a big difference to the final value of your plan, especially if they come when you’re relatively young.

Take the case of a 30-year-old who may contribute $5,000 to his RRSP for the 2001 tax year, and who hopes to retire at age 65. If he makes the contribution this year and the money is invested at 10 percent, the $5,000 will grow to about $140,000 when the time comes to retire.

But suppose he decides to use the carry-forward and delays contributing the money for five years. At age 35, he finally gets around to it. Again assuming growth in the RRSP at 10 percent a year, his $5,000 contribution will now only be worth about $87,000 when he retires. In other words, the five-year delay has reduced the final value of his RRSP by more than $50,000!

The following table illustrates how much the end value of an RRSP is reduced at various ages by delaying a $5,000 contribution. We’ve assumed retirement at 65 and an average annual rate of return of 10 percent. As you can see, the younger you are and the longer you wait, the greater the negative impact of using the carry-forward on the end value of your RRSP.

The Cost of Waiting

Length of Delay

Age Now

1 year

3 years

5 years

30

$12,750

$34,950

$53,250

40

4,900

13,450

20,500

50

1,900

5,200

7,950

60

750

2,000

3,050

There was one other drawback to using the carry-forward that had been highlighted in previous editions of this book: increased exposure to the alternative minimum tax (AMT). This tax was originally intended to prevent high-income Canadians from using a variety of tax shelters to reduce their taxable income to zero, or close to it.

Prior to 1998, Ottawa treated RRSP and RPP contributions as tax shelters and required that these amounts be added back to taxable income for purposes of calculating the AMT. However, an increasing number of middle-income earners were being caught by the AMT through use of the carry-forward. This happened in cases where people built large carry-forward credits and then claimed them all in a single year, perhaps because an inheritance or a large bonus provided the extra cash to do so, or because they took out an RRSP catch-up loan. As well, many people who used the retiring allowance rule to shelter severance payments from immediate tax by transferring them to an RRSP were hurt by this rule.

Fortunately, this is no longer a concern. The 1998 federal budget entirely removed RRSP and pension plan contributions from the AMT calculation. In fact, the change was made retroactive all the way back to the 1994 tax year. So if you were assessed AMT on the basis of a large RRSP contribution, the Canada Customs and Revenue Agency should have sent you a refund.

Clearly, the carry-forward is a double-edged sword. Properly used, it offers some much-needed flexibility and can be a valuable tax planning tool. But allowing it to become an excuse for putting off to tomorrow what you should be doing today can end up costing you many thousands of dollars. That’s a trap to avoid at all costs!