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Canada Revenue Agency: Avoid This 1 Huge RRSP Mistake

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Before the Tax-Free Savings Account (TFSA) became Canadian investors’ foremost choice for saving and investing, thanks primarily to its tax-free nature, there was the RRSP. It has been with us for about 63 years and was created to offer an opportunity for Canadians to grow their wealth in a tax-shelter for their retirement years. Even with the TFSA in the mix, the RRSP hasn’t lost its worth, and there are several reasons why investors should invest in both these accounts.

One of the most prominent benefits that the RRSP has is that its contributions are tax-deductible. Thus, you get to save a portion of your income and allow it the chance to grow in a tax-sheltered environment, while simultaneously reducing your tax burden. Another edge that an RRSP has is its generous contribution limit, and therein lies the possibility of a big RRSP mistake.

 One major RRSP mistake

The RRSP contribution limit is quite generous. It’s not a uniform dollar amount for all, which would have been much easier to understand, as is the case with the TFSA. Instead, it’s a percentage of your earned income (18%). There is a maximum contribution limit, though, $27,230 for 2020. But to contribute that much, your earned annual income should be a bit above $150,000, putting you in the minority.

But since there is no set dollar limit, and the amount you can contribute to your RRSP varies with your earned income, there is a chance that people might over contribute. The penalty is 1% of the over-contributed amount per month. So if you’ve over-contributed by a significant margin, say $20,000, your first month’s penalty alone would be $200. In 12-months, your $20,000 will be reduced to $17,728.

The best way to resolve the situation is by withdrawing the excess amount the moment you figure out about the excess contribution. It would be subjected to withholding tax, as all RRSP withdrawals are, but you can get it waived by filing the right form.

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A simple solution

The easiest solution to this problem is to know your contribution limit. You can check it from your CRA account. And on the off chance that you think that the generous RRSP limit is not enough to get you to your retirement goals, rather than over-contributing and getting penalized, you can expedite the growth of your portfolio, or you can invest in dividend stocks so your RRSP can accumulate cash from within.

Currently, the market is ripe with generous yields, like the one Atrium Mortgage Investment (TSX:AI) is offering right now. The 8.4% yield is sizeable enough to keep adding a generous amount of cash to your RRSP, depending on how much you’ve invested in the company and whether or not you have opted for dividend re-investment.

The company is not too shabby on the capital growth front either. Its share price increased very steadily in recent years (before the crash). Once the housing market settles down, the company might start growing at its previous pace and pattern. Another good thing about the yield on offer is that it didn’t slash its dividends during the market crash, and the payout ratio hasn’t changed much from previous years.

Foolish takeaway

An RRSP is a powerful tool that can help you build your wealth for your retirement years. But learning more about its nuances and strengths can help you use it more effectively. It will also help you with better asset management, as you’ll know which of your assets would do best in the RRSP, and what you should instead place in your TFSA.

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This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Adam Othman has no position in any of the stocks mentioned.

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