Deciding how to divide your savings between a registered retirement savings plan (RRSP)and tax-free savings account (TFSA) to maximize the tax benefits can be challenging. But there are some mistakes that can really cost you, especially if you run afoul of the

Canada Revenue Agency (CRA). With just a month to go until the March 2 RRSP contribution deadline, here are five mistakes to avoid.

Choosing the wrong plan

One of the most common questions I get asked is: With limited funds, how do you choose between contributing to an

RRSP or a TFSA ? The two plans are meant to be tax-neutral when marginal tax rates are constant.

Consider a taxpayer who is in a 40 per cent marginal tax bracket and who earns, for the sake of illustration, $5,000 of employment that she can either invest in an RRSP or TFSA. In the TFSA scenario, the $5,000 is taxed upfront, when earned, at the individual’s marginal tax rate, and the after-tax amount of $3,000 is invested in the TFSA. Since this tax is literally “pre-paid,” and since the earnings and growth inside the TFSA are not taxed during the accumulation phase, nor are they taxed upon withdrawal, the after-tax value after 20 years, assuming a five per cent growth rate, would be $7,960.

By comparison, take the example of $5,000 of income that you don’t pay tax on immediately because you contribute it to your RRSP and claim a tax deduction against your income for it. The $5,000 invested grows to $13,266 and is ultimately taxed upon withdrawal in 20 years at 40 per cent. You net exactly the same amount after-tax, or $7,960.

While it appears that the two plans produce the same results, this only holds true if your tax rate when you contribute to the plan is the same as your tax rate when you withdraw from the plan. RRSPs may make more sense when the tax rate upon withdrawal is expected to be lower than the tax rate upon original contribution. Conversely, TFSAs may mean you pay less tax overall, if your tax rate (including the effect of RRSP withdrawals on benefits such as the Guaranteed Income Supplement or Old Age Security pension, which are clawed back based on income) will be higher upon withdrawal than it was when you contributed.

But the math doesn’t tell the full story, since TFSAs are much more flexible. For example, the savings withdrawn can be re-contributed back into the TFSA generally in the year after withdrawal (or anytime thereafter). This can’t be done with RRSPs without using new RRSP contribution room.

On the other hand, RRSP contributions can be a useful tool in lowering your income so that you qualify for various income-tested government benefits, such as the Canada Child Benefit or the newly renamed and enhanced

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Overcontributing

Canada Groceries and Essentials Benefit (formerly the GST/HST credit). Whether you ultimately decide to contribute to a TFSA or an RRSP, it’s critical to stay on top of your contribution limits, lest you face a penalty tax for overcontributions.

Accidentally overcontributing to either a TFSA or an RRSP seems to be a

recurring problem for some taxpayers, evidenced by the continuous flow of newly-reported cases in which taxpayers go to court trying to wiggle out of the punitive overcontribution tax they’ve been assessed.

Excess contributions are taxed at the rate of one per cent per month, with the exception of a $2,000 overage permitted with RRSP contributions. The Canada Revenue Agency (CRA) has the discretion to waive this overcontribution tax if the excess contribution occurred because of a “reasonable error” as long as “reasonable steps” were taken to eliminate the excess. If the CRA refuses to waive the tax, then taxpayers have the right to seek a

Day trading in your TFSA

judicial review of the CRA’s decision in Federal Court. If you actively trade marketable securities in your TFSA, the CRA may consider this activity to

constitute a business , and the TFSA, rather than being tax-free, could be subject to tax on its business income. Frequent trading in a TFSA has been a focus area for the CRA’s audit and reassessment activities.

Generally, the CRA will look at several factors when deciding whether a taxpayer’s gains from securities constitute carrying on a business, including the frequency of the transactions, the duration of the holdings, the intention to acquire securities for resale at a profit, the nature and quantity of the securities and the time spent on the activity.

The same rule, however, doesn’t hold true for frequent RRSP trading, provided the RRSP is invested exclusively in “qualified investments.” These include most common investments, such as guaranteed investment certificates, most securities listed on a designated stock exchange, mutual funds and segregated funds. A comprehensive list of qualified investments can be found in the

CRA’s Folio S3-F10-C1 , Qualified Investments — RRSPs, RESPs, RRIFs, RDSPs and TFSAs.

Forgetting about withholding tax on foreign dividend income

Foreign dividends are not eligible for the dividend tax credit, and are taxed at your full marginal tax rate when earned outside of an RRSP or TFSA. But the problem with foreign dividends is that in most cases, a nonresident withholding tax (typically 15 per cent) is applied by the foreign jurisdiction before the dividend is received in Canada.

If you hold the foreign stock in a non-registered account, you can generally claim a foreign tax credit against your Canadian tax payable for the amount of tax withheld. But if the foreign dividend is paid into an RRSP or TFSA, any foreign tax withheld is non-recoverable and no credit is available, with one exception. Under the Canada-U.S. tax treaty, U.S. dividends are exempt from withholding tax when paid to an RRSP or registered retirement income fund (RRIF). But that same break does not apply to a TFSA, making U.S. dividend-paying stocks better off in RRSPs.

Leaving contributions in cash

Finally, while it may seem obvious to most of us, don’t forget to actually invest your RRSP or TFSA contributions, rather than leave them sitting in cash. Remember that, in most cases, the main benefit of contributing to an RRSP or TFSA is not the tax deduction (with an RRSP) or the tax-free withdrawal (with the TFSA), but rather the tax-free rate of return you are earning in either plan.

As I discussed in my RRSP column last month, if you’re in the same tax bracket when you withdraw RRSP or TFSA funds as you were when you contributed, if the funds haven’t grown, you’ve missed the primary benefit of contributing.

So, while it may make sense to leave your initial investment in cash until you decide how you want to invest it, don’t let weeks, months or even years go by without coming up with an investment strategy for those contributed funds.

Jamie Golombek, FCPA, FCA, CFP, CLU, TEP, is the managing director, Tax & Estate Planning with CIBC Private Wealth in Toronto. Jamie.Golombek@cibc.com

Read more from our TFSA vs. RRSP series

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