I have always enjoyed receiving emails from readers and connecting with like-minded people. Recently a reader asked me the following question:
Does it make sense to take advantage of the $2,000 RRSP contribution buffer and deliberately over contribute $2,000 to my RRSP? $2,000 compounded at 8% per year over 30 years would result in over $20,000!
What an interesting and thought-provoking question! Can you take advantage of this $2,000 RRSP contribution buffer and benefit from it? The reader and I went back and forth for a bit before we came to a verdict. Since I’ve been spending quite a bit of time on how to be tax efficient during retirement years, I thought I should share the analysis as a blog post.
Before we deep dive into this question, let’s go over some basics.
What is the RRSP contribution room?
The amount of RRSP contribution room you have is either 18% of your previous year’s pre-tax earned income less your previous year’s pension adjustment, or the annual maximum of $29,210 in 2022, whichever is lower. The earned income usually means employment or self-employment income but it can also include rental income, business income, etc.
The RRSP contribution room is cumulative and can be carried forward each year. So if you’re anticipating making more money next year and moving to a higher tax bracket, it may make sense to carry forward your RRSP contribution room to next year.
The $2,000 RRSP contribution buffer
Per the CRA, you are allowed to over-contribute up to $2,000 to your RRSP without penalty. The over-contribution limit exists because the CRA understands that taxpayers may inadvertently overcontribute to their RRSPs. In other words, there’s a $2,000 RRSP contribution buffer, in case you happen to go over your contribution limit by accident. This is very different from the strict TFSA contribution limit. Furthermore, it is also different from deliberately over-contributing.
If you contribute more than $2,000, you will need to pay an overcontribution penalty. The CRA charges a 1% penalty per month on the amount in excess of $2,000 until the overcontribution amount is withdrawn from your RRSP.
Please note that the $2,000 over-contribution room is not available to anyone who is under the age of 18, at any time during the calendar year.
Some additional clarification
It is important to note that the $2,000 buffer is a one-time buffer, not a yearly buffer. For most people, this buffer tends to reset itself every year as you can see from the example below.
Let’s assume that you have a $10,000 RRSP contribution limit for 2022 and you end up contributing $12,000 in total. You can only get an RRSP deduction of $10,000 in 2022 and carry forward the $2,000 to 2023. In 2023, let’s assume you’d have $11,000 in RRSP contribution limit. Since you have already contributed $2,000 in the previous year, you should only contribute $9,000 to your RRSP and deduct $11,000 in your 2023 tax filing.
Having said that, you may decide to contribute $11,000 in 2023 and carry forward the $2,000 buffer to 2024, or indefinitely, since CRA allows for a buffer of $2,000.
The tricky part is that if you happen to make a mistake and contribute more than you’re allowed, you will have to pay the 1% penalty (i.e. if you are contributing to a group RRSP through your work and you receive a bonus which leads to more money going into your group RRSP).
Can you take advantage of the $2,000 RRSP contribution buffer?
So the question is, does it make sense to take advantage of this $2,000 RRSP contribution buffer and somehow benefit from it?
The reader is absolutely correct, the $2,000 RRSP contribution buffer can add up to a significant amount of money over time. Say you use this $2,000 buffer when you’re 20 years old and let that money compound at 8% (roughly the historical long term return for the stock market) for 40 years. At the end of 40 years, you’d end up with $43,339.04. That’s a significant amount of money whichever way you slice it.
So does it mean that we should all contribute that extra $2,000?
Well, as you can tell by now, the over-contribution is not tax-deductible when contributed to your RRSP, and is taxed upon withdrawal. The benefit of over-contributing is that the over-contribution stays in the RRSP and compounds on a tax-deferred basis.
If you decide to deliberately over-contribute, I believe it is a good idea to use up the over-contribution as part of some future year’s regular RRSP contribution room.
For example, let’s assume again that your RRSP contribution limit is $10,000, but you contributed $12,000 to your RRSP. In a future year, perhaps just before retirement, let’s assume your RRSP deduction limit for the year is $10,000. You could contribute just $8,000 to your RRSP. Since you already over-contributed by $2,000 in the previous year, you’d be entitled to claim a total RRSP deduction of $10,000 ($8,000 for the current year’s contribution plus the $2,000 that was previously contributed but not deducted for tax purposes).
Now you may wonder, couldn’t I just carry this buffer indefinitely and never claim the $2,000 tax deduction?
Well, let’s not forget the advantage of RRSP – tax deferral. When you contribute money to your RRSP, you get a tax deduction. The key concept is that you’d maximize the amount of tax deduction during the working year because your marginal tax rate is higher. When you’re retired and rely on withdrawals from your RRSP, hopefully, your marginal tax rate is lower than during your working years.
If you never claim the $2,000 tax deduction, it simply means that when you withdraw the money, it is then taxed at your marginal tax rate. Since you didn’t get any tax deduction (i.e. 0%), you’d end up paying a higher tax rate upon withdrawal, which defeats the idea of having an RRSP in the first place!
So does it make sense to take advantage of the $2,000 RRSP contribution buffer? Yes, I believe so but do pay attention to your yearly contribution limit and how you plan to deduct this $2,000 contribution limit in future years.
Rather than over-contribute $2,000 to your RRSP and having to pay taxes upon withdrawal in future years, I think it is far more beneficial to contribute this $2,000 to your TFSA. If you happen to max out your TFSA, I believe the next best option is to simply invest the $2,000 in a taxable account. If the $2,000 happens to grow to over $40,000 after 40 years of compounding, thanks to the capital gain tax rule, you’re only taxed 50% of your gain at the marginal tax rate. This is far more tax-efficient than being taxed at your full marginal tax rate with an RRSP withdrawal.
Finally, don’t be naive and think you can cheat the CRA. The CRA, aka Johnny Canucks, will always get their share of tax money one way or another. Therefore, it is important to find ways to be tax-efficient, that are legitimate and legal that would minimize your taxes.
Note: I’m not a tax specialist so before you consider using the RRSP $2,000 buffer it is advised to consult with a tax specialist.