Yesterday I talked about how over-over-contributing to your RRSP can make sense in a very special circumstance – since the balance is subject to a hefty 1% PER MONTH penalty. I thought I would talk today about the "regular" over-contribution limit since I have never really mentioned it before.
(I know a lot of people will have heard that you should use it – but I would warn you to read the following first – otherwise you could subject yourself to some nasty double-taxation!)
You are allowed to over-contribute to your RRSP by $2,000 without incurring any penalties – but note that the contribution does not qualify as an income deduction for that tax year. Ultimately that means you can add the $2,000 to your RRSP account but not expect any tax reduction on your tax return for it.
So why would you want to over-contribute? That $2,000 will still grow tax-free once it is inside your RRSP – and I’m sure you’ve been beaten to death about the advantages of tax-free compounding – so you can probably figure out why this is a good thing.
This is really advantageous for people who maximize their RRSP from the get-go and continue to do so each year. The advantage becomes slightly more "academic" if you do not continue to maximize your RRSP thereafter since any new RRSP room created but not used will restore the $2,000 over-contribution limit.
Having the $2,000 over-contribution balance if you plan on making withdrawals from your RRSP (except for the home-buyer’s plan and the lifelong-learning plan) is a VERY BAD IDEA – note that you will have been taxed TWICE on that money since you used "after-tax" dollars to make the over-contribution in the first place (since it was not deductible) and then you are taxed again when you withdraw funds from your RRSP – the government does not care what the tax treatment was for those funds as they went in.
So, let’s say you were in a 40% tax bracket. You had to earn $3,333 in salary to take home $2,000 in the first place – if you put that money into your RRSP as an over-contribution (which you cannot deduct) and then subsequently take it out of your RRSP at a later date – it is again taxed 40%. Your original earning of $3,333 has been reduced to $1,200 by the time you get to spend it!
You can avoid that double taxation on the withdrawal if you generate new RRSP room and use the room to reduce the over-contribution balance first – but you may want to wait an additional 90 days to avoid the 89-day contribution deductibility rule! Check with your accountant on that to be sure.
Also note, that if you have an over-contribution balance, but don’t have the means to make an RRSP contribution the following year, you can still deduct $2,000 the following year by claiming the un-deducted $2,000 over-contribution as new RRSP room is created.
So as you can see – there is more to the $2,000 over-contribution limit than meets the eye!
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