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RRSP mistakes can be costly if you don't know the rules

I have officially made my biggest mistake of the year -- so far. I took Michael, our youngest child, to the hardware store. Now, darkening the doors of the hardware store itself wasn't the problem. But visiting the store with a potty-training child who wasn't wearing a diaper, and stopping in the plumbing section by the toilets was not a smart move.

Do you think I can convince the little guy to go on the potty at home? Not a chance. But turn the other way for 20 seconds at the hardware store and his pants are down to his ankles as he's doing his No. 2 in aisle No. 3, sitting on a toilet bowl. No diaper. Big mistake. This time of year, thousands of Canadians will make some big mistakes of their own -- with their registered retirement savings plans. Let me explain.

First mistake

You've got to feel for a man we'll call Jason. He called me last week in dire need of some tax help. Jason had sold some stocks in 2004 for a $100,000 profit. Without any planning, Jason was destined to pay taxes of $23,205 on this capital gain.

Not wanting to suffer this type of tax bill, Jason did what many quick-thinking investors would do. He identified several stocks in his portfolio that had dropped in value, and decided to trigger $80,000 in capital losses, to largely offset his capital gains.

Jason's problem? He simply transferred the losers into his RRSP, as a contribution in-kind. His thinking was that he'd be able to claim the $80,000 in capital losses, and an RRSP deduction to boot, which would then offset all the tax on his gains.

Jason didn't realize that when you transfer any investment directly into your RRSP, it's considered to be a disposition at fair market value, but any losses on the transfer are denied. This mistake cost him $18,564 in tax. The solution? He should have sold his losers on the open market, then contributed the cash to his RRSP. This would have given him the result he was looking for.

Second mistake

A woman we'll call Janet also learned the hard way. Her husband had contributed $30,000 to a spousal RRSP for Janet over the years 2002 and 2003. By mid-2004, that $30,000 had dropped in value to just $2,000. Oops. Now, rather than having two RRSPs, one worth just $2,000, Janet decided to combine this spousal RRSP with her own RRSP to which she contributes each year.

Her own RRSP was worth about $50,000 at the time.

Since Janet was not working in 2004, she decided to make a $20,000 withdrawal from her RRSP. What she didn't realize is that when you combine spousal RRSP dollars with regular RRSP dollars, the entire plan becomes a spousal RRSP. That's right, her $50,000 RRSP became entirely a spousal RRSP since she had added $2,000 of spousal RRSP money to the plan.

The result is that the full $20,000 she withdrew from her RRSP will be taxed in the hands of her husband, who is in the highest tax bracket.Yikes.This mistake cost the couple $6,641 in tax.

The solution? Janet should have avoided transferring spousal RRSP dollars into her own RRSP. Then, she, not her husband, would have faced the tax on the $20,000 withdrawal. The only time you can avoid this "tainting" of regular RRSP dollars with spousal RRSP status is on separation or divorce. Even then, speak to a tax professional to ensure you're doing things properly.

Tim Cestnick, FCA, CPA, CFP, TEP, is author of Winning the Tax Game 2004, and The Tax Freedom Zone. He is managing director, tax and estate planning, at AIC Ltd. tail

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