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What you can add to your RRSP — and what you can take out of it

From a leading Canadian tax advisory we get a not-quite-last-minute guide on what to add to your RRSP — and how you can withdraw safely.

You have exactly two weeks, in case you hadn’t noticed the unusual volume of ads, billboards and other assorted promotions from financial firms in recent weeks. Your RRSP deadline is coming up.

You’d almost think that not making an annual contribution to your RRSP was akin to not filing a tax return. You become a sort of fiscal outlaw overnight.

But there’s no doubt that contributing to your RRSP is a good thing. We’re not here to discuss whether or not you should put investments into an RRSP, but which ones you should be putting in there.

To do so, we turn to one of Canada’s foremost advisories on the subject, The TaxLetter. We get two timely pieces of advice on RRSPs from Ms. Samantha Prasad, LL.B. One is about putting things in, the other about taking money out. You can give yourself a loan from your RRSP without taking a hit from the Canada Revenue Agency.

We’ll start with what goes in.

Do-it-yourself RRSPs

Most RRSP contributions are pretty straightforward, but things get a lot more interesting if you have a self-directed RRSP. The administrative fee is not tax-deductible, unfortunately, but you get to make your own investment choices.

This gives you more flexibility than simply calling up and ordering so many dollars worth of XY or Z mutual fund. It certainly gives you more control over your returns.

If you wanted to start one up before this year’s deadline, by the way, it would be easy to do so. If you wanted to transfer any investments from other accounts into it between now and the 29th, however, you might find the going rather slow.

At any rate, Ms. Prasad’s concern is that RRSP “do-it-yourselfers” know exactly what they can put into their accounts. The official lingo is “qualified investments,” and there lots of them, including two new ones for 2007.

Money, gold, REITs and Spiders

Here is the official list of what you can put into an RRSP:

1) Money, including deposits in a Canadian bank or trust company. It must be in Canadian currency.

2) Canadian government bonds, debentures or similar obligations.

3) Precious metals — specifically, investment-grade gold and silver bullion, coins, bars and certificates acquired from the producer or a regulated financial institution.

4) Shares of companies listed on a prescribed Canadian stock exchange. (“Prescribed” is tax lingo for “approved.”)

5) Units in or debt of a limited partnership listed on a prescribed Canadian stock exchange.

6) Shares listed on a foreign stock exchange, which are prescribed in Regulation 3201.

7) Warrants or rights giving the owner the right to acquire a qualified investment (“Speak with your tax adviser to ensure that you don’t trip on some of the conditions relating to this category,” adds Ms. Prasad.)

8) REITs and income trusts that are structured as mutual fund trusts. This includes units of exchange-traded funds (for example iShares S&P/TSX 60 Index Fund, or “i60.”) It also includes exchange-traded index units listed on prescribed foreign stock exchanges, such as “Spiders” (SPDRs), DIAMONDs and the like.

Puts, calls and arm’s length mortgages

9) Puts/calls/spreads. Purchasing calls instead of stocks, covered call writing and purchasing puts instead of selling stocks short have all been allowed since 2004.

10) Mortgages, as long as certain conditions are met. The mortgage must be “arm’s length” — i.e., conducted as if the parties were independent and equal and not acting on a shared interest. By the same token, the mortgage must not exceed the fair market value of the property. Your RRSP can also make you a loan secured on the property — we’ll deal with that in a while.

11) Debt obligations issued by a Canadian corporation or trust, as long as certain prescribed conditions are met.

The list of qualified securities has been expanded for 2007. It now includes any debt obligation that carries an investment-grade rating and is part of a minimum issuance of $25 million.

It also includes any security listed on a designated stock exchange — other than a futures contract or other derivative where the loss may exceed your cost.

In more specific terms, the list has grown to allow more international flexibility, allowing investors to bring in foreign-listed trust and partnership units and Canadian dollar bonds issued by foreign entities.

In short, you’re scarcely going to be at a loss to find things to put in a self-directed RRSP. But what if you want to take money out of your RRSP, self-directed or otherwise?

Making a loan from your RRSP

As a rule, of course, money drawn from an RRSP goes straight on to your tax bill as income. Or, as Ms. Prasad tells her TaxLetter readers: “We all know the cardinal rule relating to RRSP withdrawls before maturity: Don’t do it!”

So if you could use some cash, your RRSP is not normally the first place to look. But there are escape hatches — three of them, in fact. Each involves making yourself a tax-free loan from your RRSP.

“These strategies may not always make sense,” cautions Ms. Prasad. “However, when contrasted with the spectre of an out-and-out withdrawl, they usually do, because you have a chance to restore the withdrawl without penalties.”

The home buyers’ withdrawl

The first strategy applies to home buyers. The federal government’s Home Buyers’ Plan allows a tax-free withdrawl of up to $20,000. The plan is supposed to apply only to those who are buying their first home.

The withdrawl must be repaid in equal installments over 15 years, and if a minimum repayment for a year is not made, the shortfall is taxed in your income. The repayments commence in the second calendar year after the withdrawl and payments made in the first 60 days of a year count for the preceding year. So if you make a withdrawl in 2008, you must begin making RRSP repayments no later than March 1, 2011.

There’s no specific restriction on doubling up: if a home is held in co-tenancy, a husband and wife could draw out $40,000 in all.

There’s lots of small print to comply with, of course. Your Home Buyers’ Plan balance on January 1 of the year of withdrawl must be zero. You must have already signed an agreement to purchase or build a home when you withdraw the money.

The home (or a replacement property) must have been bought or built by October 1 of the year following the year in which you’ve received the funds from the RRSP. You must occupy the home as your principal place of residence within one year of buying or building it. And neither of you can own the home more than 30 days before the RRSP withdrawl.

There’s one more condition: a “look-back” rule prevents ownership of an owner-occupied home by you or your spouse (common law included) for five years.

So is it worth it? You must be very aware of the problems that could arise, advises Ms. Prasad.

Better than an outright withdrawl

You could be caught in a cash-flow crunch down the road and get stuck with tax penalties. In the first place, repayments could force you to cut back on regular RRSP contributions. “So, without the RRSP writeoff, your tax nut could go up,” adds Ms. Prasad.

It could get worse: if you fail to meet repayments — which are not deductible — you suffer a further tax hit. Even harsher penalties may come into play if one of you passes away or if you cease to become a Canadian resident.

The plan might make more sense if you’re about to drop into a lower tax bracket (say, if you’re leaving the workforce). In that case, there may be little or no adverse tax consequences from missing repayments.

“Having said this,” concludes our expert, “participating in a Home Buyers’ Plan is usually a better bet than an outright withdrawl from your plan, which is a straight add-on to your taxable income in the year of withdrawl.”

Learning for dollars

A Lifelong Learning Plan can also earn you tax-free dollars borrowed from your RRSP. This plan allows you to withdraw up to $10,000 a year from your RRSP for up to four years, to a maximum of $20,000.

To qualify for this loan, you or your spouse must be enrolled in a qualifying educational or training program — which usually means full time for at least three months of the year.

You repay the withdrawls in equal installments over 10 years, or face a tax hit. The repayments start in the year following the last year of full-time enrollment, or six years after the first withdrawl, whichever comes first.

The drawback with this strategy is pretty much the same as with the Home Buyers’ Plan: it could cut into your ability to make regular RRSP contributions. This problem could arise at a time when you’ve moved into a higher tax bracket than the one you were in when you made the withdrawl.

If this is the case, it might make more sense to fund your education with a regular taxable withdrawl from your RRSP, then make a regular tax-deductible contribution when you’re back in the workforce. The Basic Personal Exemption — $9,600 for 2007 and 2008 — plus Tuition and Education Tax Credits may well cover the withdrawl.

A true loan from your mortgage

Now here’s the only one of the three strategies that involves a true loan. The first two come with tax penalties attached if you don’t make your repayments within the stated time limits. The RRSP mortgage does not. It is a true loan.

You borrow funds from your RRSP using real estate as security. Usually, this is your principal residence — in other words, your RSSP holds a mortgage on your home.

The condition is that the mortgage must be insured by the Canada Mortgage and Housing Corporation (CMHC) or a public mortgage insurer. This exempts you from the general rule that an RRSP cannot hold the mortgage of the person holding the plan, or a family member. The RRSP mortage must meet normal commercial terms, including market interest rates.

Ms. Prasad helpfully supplies a list of public mortgage insurers: Genworth Financial Canada (the oldest), AIG United Mortgage Insurance Corp., PMI Mortgage Insurance Co. of Canada and Triad Guaranty Insurance Corp. of Canada.

You can use your RRSP mortgage to pay down an existing mortgage. In other words, instead of paying interest to the bank, you are in effect paying yourself. “In this case,” says Ms. Prasad, “your benefit is largely based on the difference between the interest rate you’d otherwise pay on your mortgage (what you “save”) and the return you’d make on your RRSP if you didn’t follow this strategy.”

Plus, if you’re paying more into your RRSP than the return you would make on a conventional investment, you will have more money compounding in your plan on a tax-deferred basis.

But you don’t actually have to use your RRSP loan to pay down your mortgage or even put the money into your home. You could, for instance, put it into a new business — if the mortgage insurer approves. What’s more, if the money is used for business or investment, the interest should generally be tax-deductible. Note that CMHC does not allow such “equity take-out loans,” so you must turn to one of the mortgage insurers.

Catching up

Finally, Ms. Prasad lets her readers in The TaxLetter in on two very interesting ways to use your RRSP mortgage.

For one thing, you can use it as a catch-up contribution to your RRSP. Here’s how. Your RRSP makes you a mortgage loan. You put the proceeds right back into your RRSP as a catch-up contribution. Presto! You get a tax deductin on the amount of your catch-up contribution.

You can also make an RRSP mortgage loan to another family member. It is even possible, in theory, to work the RRSP mortgage based on a second mortgage or even a vacation or rental property. You may not always be able to get mortgage insurances in these circumstances, however.

That’s a long list of things you can put in or take out of your RRSP. But a little extra knowledge could go a long way. More Canadians might come closer to filling their RRSPs if they knew just how much can be done with it.

In the meantime, Canada’s first-ever mid-winter holiday weekend is upon us. Enjoy Family Day. The Daily Buy-Sell Adviser returns on Tuesday.