Everything you need to know about the Registered Retirement Savings Plan (RRSP)
The Registered Retirement Savings Plan (RRSP) has been around for a long time. In 1957, the Canadian government introduced the Registered Retirement Annuity to help Canadians save towards retirement. The RRSP’s primary purpose of saving for your golden years remains the same after all these years.
In this article, we’ll take an in-depth look at the RRSP, the Tax-Free Savings Account’s (TFSA) older, wiser sister. With the lack of workplace pension plans, employees must save towards retirement. An RRSP is arguably the best way to do so.
What is an RRSP?
The Registered Retirement Savings Plan is a tax-sheltered account for your investments. It reduces the amount of income tax you’ll pay while you’re working so you can save more for retirement. You can claim a tax deduction on any money you contribute to your RRSP in the current calendar year. There are taxes for the investments inside your RRSP if you do not withdraw them.
Another option is to contribute to your spousal RRSP or your common-law partner’s. You can even join a group plan at your workplace. Ask questions to help determine the type of account that’s right for you.
How does it work?
The main is that the money you contribute stays in the plan until you reach 71 years of age. You can then withdraw the money you’ve accumulated over your working years as a lump sum or periodically.
You’re able to claim a tax deduction each year for the amount contributed to your RRSP. You’ll then receive a tax refund from the Canada Revenue Agency (CRA) when you file your tax return. Your tax refund depends on how much you’ve contributed to your RRSP and your federal and provincial tax bracket.
But you do not have to claim your full RRSP contribution each year. You have the option of waiting to claim it in the future. This can make sense if you want to start saving towards retirement early on in your career, but you’re not earning enough to make full use of the tax deduction.
Taking Money Out of the Account
If you take the money out of your account at any point (except for the Home Buyers’ Plan or Lifelong Learning Plan), that amount becomes taxable income.
Similar to the TFSA, you can hold a slew of investments inside your RRSP. These investments include stocks, bonds, savings accounts, GICs, mutual funds, exchange-traded funds (ETFs) and index funds.
For those who grew up during the 2008 financial crisis, it can be tempting to park your RRSP money somewhere safe, like a regular savings account held inside your RRSP. But by doing that, you’re taking on a new form of risk, since your money may not grow fast enough to keep up with inflation. That’s why it’s best to invest based on your risk tolerance and time horizon.
What are the advantages of a Registered Retirement Savings Plan?
If you ask anyone what the most significant advantage of having an RRSP is, they’ll most likely say the tax deduction. By contributing to your RRSP, you’ll be eligible for a tax deduction when you file your tax return. This means that your taxable income will lower when you file your taxes, which could even put you in a lower tax bracket.
Another significant advantage of the RRSP is that your money grows tax-free. As long as your money stays invested inside your RRSP, you won’t have to pay any income tax on your investments. This includes income, dividends and capital gains. The tax savings combined with the power of compound interest can help your money grow substantially by the time you’re ready to withdraw the funds.
Although you won’t have to pay any taxes on your investments, you’ll have to pay tax when you withdraw the money from your account. However, if you’re like most people, you’ll be in a lower tax bracket in retirement and pay less when you access your money.
What are the disadvantages of an RRSP?
If you’re a high-income earner, the RRSP limits the amount of money you’re able to tax shelter for retirement. That’s because RRSPs have a maximum amount you can contribute in any given year (more on that later). If you’re in a high tax bracket, you’ll need to find other ways to invest, or you could face a significant decrease in your standard of living during your golden years.
If you’re thinking about holding risky investments in your RRSP, you might think twice about doing so. That’s because you can’t claim capital losses on investments sold inside your RRSP. You also aren’t eligible for the preferential tax treatment of capital gains and dividends when selling stocks, mutual funds, index funds and ETFs in your RRSP.
Unlike the TFSA, the government taxes RRSP withdrawals. Not only will you lose the RRSP contribution room forever, but you could also face withholding taxes and be required to pay even more in taxes when you file your return, depending on your tax bracket.
TFSAs can remain open as long as you’re alive, RRSPs cannot. As mentioned, you have to convert your RRSP to a Registered Retirement Income Fund (RRIF) or purchase an annuity by December 31 of the year you reach 71 years old. You also have the option of fully cashing out your RRSP, but tax hits negate the tax benefits of the RRSP.
Converting to an RRIF
If you choose to convert your RRSP to an RRIF, you’re must withdraw a minimum amount according to your age. The minimum amount increases as you get older. Since these minimum withdrawal amounts were made when interest rates were higher, you could find yourself forced to withdraw more than you’re comfortable with and eat into your capital, putting you at risk of running out of money before you pass away.
You can avoid this by supplementing your RRSP income with your TFSA and non-registered account investments.
Any money you withdraw from your RRSP and RRIF counts as taxable income. As such, you could find yourself ineligible for means-tested government benefits, such as Guaranteed Income Supplement (GIS). You could also find your Old Age Security (OAS) partially or fully clawed back.
For people who expect to earn more in retirement or for those who plan to make substantially less, you might be better off not contributing to it, as it could end up costing you a lot in government benefits. It’s best to consult with an accountant who can help run the numbers and see whether contributing to your RRSP makes sense.
How do you open one?
If you’re between the ages of 18 and 71 and you file a tax return, you can open an RRSP.
Similar to any investment, you should take the time to shop around. Do your homework before deciding. High investment fees can eat into your investment returns long-term, so make sure to check out all the expenses involved.
Once you decide which financial institution you’d like to invest with, complete all the paperwork to open your account. Complete the “Know Your Client” form indicating your knowledge of investing and risk tolerance. Name beneficiaries to your RRSP if anything were to happen to you.
Provide two pieces of photo ID. You can open an RRSP account at the majority of financial institutions in Canada, including banks, credit unions and insurance companies. Once your account is open, you can contribute or transfer money from an existing account.
How much can you contribute?
The amount you can contribute, otherwise known as your RRSP contribution room or deduction limit, depends on how much employment income you earn. You can contribute up to 18 percent of your earned income from the prior year up to a maximum amount set by the government. For example, the maximum amount you can contribute to your RRSP in 2019 is $26,500.
The maximum amount typically increases each year with inflation. You can usually find your RRSP contribution amount for the year on the notice of assessment you receive from the government after filing your taxes. If you’re part of a company pension plan, the amount you can contribute to your RRSP reduces. This is to help level the playing field since most people don’t have the benefit of an employer-sponsored pension plan.
The reality is that most Canadians don’t contribute the maximum amount to their RRSP. You won’t lose the contribution room, as it’s carried forward and can use it in the future.
Your taxable income reduces when you contribute to your RRSP. For example, if you contribute $3,000 to your RRSP and your taxable income is $75,000, your taxable income is $72,000 after you make your RRSP contribution.
What happens if you want to contribute more than the limit?
The good news is that the RRSP is a lot more forgiving than the TFSA. With the RRSP, you can contribute $2,000 above your contribution limit without facing any penalty. However, you’re not able to claim a tax deduction for the over-contributed amount.
If you contribute beyond the $2,000 leeway amount, you’ll face a 1 percent penalty tax per month on the over-contributed amount.
Can you withdraw money from your RRSP before you retire?
Yes, provided it’s in a non-locked in RRSP (not from a company pension plan), you can withdraw your funds at any time. But don’t forget, you’ll lose the contribution room forever, you’ll face withholding taxes, and could face further taxes when you file your tax return.
Despite this, there are two instances when you can withdraw funds from your account without facing a tax hit.
You can withdraw up to $25,000 from your RRSP towards the purchase of your first home ($50,000 when buying with a partner). This is known as the Home Buyer’s Plan. The strict rules require that you pay back any money you withdraw within 15 years, starting in the second year after the withdrawal.
The second instance when you can withdraw funds from your RRSP without penalty is for going back to school. With the Lifelong Learning Plan, you can withdraw $10,000 annually, for a total of $20,000 borrowed, although you have to pay back the money in 10 years.
What is the difference between an RRSP and TFSA?
Although the RRSP is less flexible than the TFSA, it offers several of its own advantages.
First and foremost, contributions to your RRSP are tax-deductible, while TFSA contributions are not. That means your tax advantages (savings) are immediate when contributing to an RRSP.
The RRSP and TFSA are both similar in the sense that your money grows tax-free inside both accounts. However, the TFSA catches up later on. When you make withdrawals from your RRSP, the income is taxable. This is unlike the TFSA, where withdrawals do not count as taxable income.
The TFSA is also a lot more flexible in terms of when and how often you can access your money. You can recontribute any money withdrawn from your TFSA on January 1 of the following year. This is unlike the RRSP, where for any withdrawals, you’ll lose the contribution room forever.
If your RRSP is locked in, there are further restrictions on when you can access the funds. In most cases, you won’t be able to access the funds until at least age 55. At that point, there are restrictions regarding the types of investments you can buy (i.e. an annuity or a locked-in life income fund).
Your earned income from the prior determines your RRSP contribution limit. To contribute to your RRSP, you must have earned income. That means if you’re retired and only earning revenue off of investments, you won’t accumulate the RRSP contribution room anymore.
This is different from the TFSA, where everyone accumulates the same amount of contribution room each year regardless of income. Furthermore, you don’t have to have earned income to contribute to your TFSA. You can keep adding to your TFSA even when you’re retired.
Another key difference is the maximum age. You’re only able to keep your RRSP open and contribute until age 71. With the TFSA, you can keep it open as long as you’re living.
Unsure of whether you should be contributing to a TFSA or RRSP? A good rule of thumb is that if you earn less than $50,000, you’re usually better off contributing to the TFSA. If you earn more than $50,000, an RRSP often makes the most sense.
Everyone’s tax situation is different, so it’s best to consult with an accountant.
As you can see, RRSP benefits the vast majority of Canadians, but RRSPs don’t make sense for everyone. By understanding how RRSPs work and working with a good accountant, you can figure out how to make the most of your contributions.