WHAT IS AN RRSP & HOW DOES IT WORK?

WHAT IS AN RRSP & HOW DOES IT WORK?

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Would you rather take a nap than try to figure out all the finance mumbo jumbo (RRSPs, TFSAs, RESPs)? 

You are not alone. 

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For a long time, I really did not want to think about it either. I mean, isn’t studying and working hard enough responsibility already? But this was until I realized how much money I was leaving on the table.

As it turns out, an RRSP can save you a ton of money!

You may have never contributed to an RRSP before, or you may have made some contributions but are not sure how to take advantage of it entirely. Well, I am glad you have landed on this post.

In this article, we’ll take a look at the RRSP and cover all its basics to help you decide whether it is a good option for you.

What is an RRSP?

RRSP stands for Registered Retirement Savings Plan. (I’m with you if you think this is quite a dry-sounding name).

But stick around because the benefits of an RRSP are pretty exciting!

The Canadian Government established it in 1957 to encourage employees and self-employed people to save for retirement.

The Canada Revenue Agency (CRA) oversees the RRSP and sets all its rules (contribution limits, contribution timelines, and types of investments allowed).

An RRSP is a tax-sheltered saving and investment account. Anyone under the age of 71 with a social insurance number and earned income can contribute to an RRSP.

The RRSP’s magic is that contributions lower your taxable income and tax on investment income is deferred until retirement.

It is a pretty big deal!

RRSP Contributions

Because of the significant tax benefits of RRSPs, the CRA puts a limit to contribution amounts.

(Otherwise, we would all put our monies in RRSPs and never pay taxes! Wouldn’t that be awesome? But I digress.)

Your annual contribution room is equal to the lesser of :

  • 18% of your earned income in the previous year or
  • The yearly maximum amount established by CRA.

For the year 2021, the maximum annual contribution is $27,830.

Illustration:

  • If you earned $100,000 in 2019, your contribution room in 2020 will be $18,000 ($100,000 x 18%)
    • If you earned $200,000 in 2019, your contribution room in 2020 will be capped at $27,230. This is because $36,000 ($200,000 x 18%) exceeds the allowable contribution amount.

The table below shows the annual contribution limits for the last ten years.

YEAR CONTRIBUTION LIMIT
2020 $27,230
2019 $26,500
2018 $26,230
2017 $26,010
2016 $25,370
2015 $24,930
2014 $24,270
2013 $23,820
2012 $22,970
2011 $22,450

Another great thing about RRSPs is that any unused contribution room is carried forward to future years; you do not lose it!

You can find your available contribution room at the end of your Notice of Assessment.

Earned Income

Earned income includes a sum of any of the following:

  • Pre-tax salary earned from employment
  • Net income from self-employment (side hustles!)
  • Net income from active business partnerships
  • Rental income (net of expenses)
  • Research grant money (net of expenses)
  • Employment-related expenses
  • Rental property losses

Other RRSP contribution Rules

Here are some other nuggets to keep in mind before making an RRSP contribution:

  • Your contributions have to be made in the first 60 days of the following calendar year to deduct them from your income in a given year.

  • So, for example, for 2020 tax deductions, you have up to March 1st, 2021, to make your contributions.

  • The contributions made to an RRSP (within your contribution limit) reduce your taxable income in that year or a future year.

  • You can choose to apply the reduction in the following year(s) if you expect to have a higher income later.

  • An RRSP tax deduction will have a more significant impact as your income increases and you move into a higher tax bracket.

  • There is a penalty for over-contributing to an RRSP. The CRA will charge a 1% monthly fee on the excess amount, i.e., a 12% annual fee!

  • But the CRA understands that mistakes happen. As such, CRA provides a $2,000 excess contribution room, in addition to your allowable contribution limit.

  • Penalties do not apply to the first $2,000 of any excess contribution.
    • Consequently, you cannot deduct this $2,000 from your taxable income.

RRSP Withdrawals

Contrary to popular belief, you can withdraw from an RRSP account at any time. But since the Government wants you to save for retirement, there is a catch on withdrawals!

Here is what you should know before making a withdrawal:

  • When you withdraw from an RRSP account, the financial institution is required to withhold tax. The tax depends on the withdrawal amount; refer to the table below.

  • Withholding tax is not a penalty. It is merely the tax that you deferred when you contributed to an RRSP.

  • If the withholding tax applied by the financial institution is higher than your actual tax rate, you will receive a tax refund when you file your taxes. Otherwise, you will have to pay the difference to the CRA.

  • Also, keep in mind that you lose the contribution room permanently when you withdraw from an RRSP.

RSSP WITHDRAWAL WITHHOLDING TAX RATE [EXCEPT QUEBEC]*
Up to $5,000 10%
Over $5,000 up to $15,000 20%
Over $15,000 30%

*Quebec has a province-specific withholding tax rate. If you hold funds in Quebec, you can find out more from your financial institution or Revenue Quebec.

Eligible Tax-Free Withdrawals

CRA provides for two circumstances where you can withdraw from your RRSP without incurring an immediate tax liability. These two circumstances include:

Home Buyer’s Plan (HBP) Withdrawal

  • HBP is a program that allows you as a first-time homebuyer to withdraw from an RRSP to buy or build a home.
  • The current withdrawal limit under this program is $35,000.
  • The withdrawn amount has to be repaid within 15 years, starting in the second year after the year of the withdrawal.
  • Should you make a repayment that is less than the required yearly amount, the difference adds to your taxable income.

Lifelong Learning Plan (LLP) Withdrawal

  • LLP is a program that allows you to withdraw from your RRSP to finance full-time education for yourself or your spouse or common-law partner.
  • It does not include financing education for your children.
  • The current withdrawal limit under this program is $10,000 per year up to $20,000
  • The withdrawn amount has to be repaid within 10 years, usually repaying 1/10 of the total amount withdrawn each year

Investments you can hold in an RRSP

Eligible investments for an RRSP account are called qualified investments. As per the CRA guidelines, below are the qualified investments.

  • Cash
  • Guaranteed Investment Certificate (GICs)
  • Mutual Funds (RRSP-eligible ones)
  • Bonds
  • Exchange-Traded Funds (ETFs)
  • Stocks (Canadian and Foreign)
  • Mortgage-backed Securities
  • Canadian Mortgages
  • Certain shares of small businesses and venture capital corporations
  • Real Estate Investment Trust (REITs)
  • Options

Types of RRSPs

There are three main types of RRSP accounts:

  • Individual RRSP: This is an account registered under your name and to which you are the sole contributor.
    • Contributions lower your taxable income
    • Upon retirement, you can make withdrawals from your account at a lower tax bracket

  • Spousal RRSP: This is an account registered under one spouse’s name, and the other spouse can contribute to it.
    • The contributing spouse receives the tax deduction, which doesn’t affect their spouse’s contribution limit.
    • At retirement, both spouses withdraw from their respective accounts, and the income is subject to their individual tax rates.  

  • Group RRSP: These are accounts set up under a group, such as employees of a company or members of a professional organization.
    • Group RRSPs receive benefits such as reduced administration or management fees
    • Members of a Group RRSP are responsible for keeping track of their individual contribution limits

How to open an RRSP

There are plenty of options on where to open an RRSP account. You can open one at a financial institution such as a bank, credit union, trust, or insurance company.

Keep the following items in mind when selecting a financial institution:

  • Look for an institution that does not require a minimum investment amount
  • Consider the types of investments offered and the fees charged

Once you have decided on a financial institution, the process to open an RRSP is quite simple.

All you need is two pieces of identification, fill out an application form, fund the account, and you are on your way to some awesome tax-savings!  

RRSP Benefits

As you can tell by now, the RRSP is quite a phenomenal savings and investment account. Below is a summary of the significant benefits that it provides:

1. It allows you to defer your taxes to a future date, ideally when you retire and are in a lower tax bracket. Generally, people have a lower income in retirement. As such, retirees will typically be in a lower tax bracket than previously during their higher-income years.

2. It is a tax-sheltered account that allows your investments to grow tax-free. This feature of an RRSP lets your investments grow faster than they would in a taxable account.

3. The Canada-US Tax Treaty recognizes an RRSP as a tax-deferred account for US tax purposes. Therefore, any US investment income within an RRSP is tax-sheltered. (Note: this is not the case in a TFSA. US investments in a TFSA are subject to a 15% withholding tax).

You can learn all about the TFSA here.

4. Withdrawing from an RRSP results in an immediate tax liability that can disincentivize you from relying on it for short-term needs. This withdrawal deterrent consequently encourages long-term investment that can help you to achieve financial independence much faster.

Differences between a TFSA and an RRSP

The TFSA and RRSP are both excellent tax-sheltered accounts that you can use to accelerate your wealth growth.

Given that they are both fantastic accounts, you may be wondering which one you should prioritize. Depending on your goals, one may be better for you than the other.

To help you decide what works best for you, the table below summarizes the main differences between a TFSA and an RRSP:

  TFSA RRSP
Contribution Limits Annual limit changes each year. Max for 2020 is $6,000 Annual limit equals 18% of the previous year’s earned income, up to a limit of $27,230
Withdrawals Can withdraw at any time, tax-freeWithdrawals can be “re-contributed” in the following years Can withdraw at any time, subject to paying income taxWithdrawals cannot be “re-contributed” except within the HBP* and LLP** programs
Tax Deductibility Contributions are not tax-deductible Contributions are tax-deductible in the current or future years
Tax on Investments Tax-sheltered growth on investments Tax-sheltered growth on investments
Expiration There is no expiry Must be converted to a Registered Retirement Income Fund (RRIF) when you turn 71.
*Home Buyers Plan **Lifelong Learning Plan

Common RRSP mistakes to avoid

An RRSP can save you a lot of money and help your investments to grow so much faster. But if used incorrectly, you can miss out on a lot of its magic.

Here are some common mistakes to keep an eye on:

  • The RRSP’s name is misleading because it is not at its best when used as a savings account; instead, you can realize its full potential as an investment account.

  • People who use an RRSP as a savings account miss out tremendously on the benefits of deferring tax on investment income and growing investments tax-free.

  • Over-contributing to your RRSP. While 18% of your earned income provides for a substantial contribution room, it is easy to go over the limit when you are part of an employer matching program. Your contributions (including employer contributions) should not exceed the 18% limit.

  • When you withdraw from an RRSP too early, you will pay taxes at your individual rate and forfeit that contribution room forever.

  • It would be much cheaper to borrow from a personal line of credit than to pay tax on a withdrawal. As such, to make a withdrawal from an RRSP should be your very last resort.

  • Another common RRSP mistake is failing to reinvest tax refunds. You can think of the tax refund resulting from making RRSP contributions as a deferred tax liability.

  • While you did not have to pay the income tax today, you will have to pay it down the line during retirement. Instead of spending your refund, you should reinvest it to provide you with even more retirement funds.

Conclusion

An RRSP is a powerful savings and investment vehicle because contributions lower your taxable income, and investments are sheltered from taxes until you make a withdrawal.

These key RRSP account features mean you will have more money available for your immediate needs or additional investments. Meanwhile, your assets will compound and grow faster due to the deferred tax liability.

As is the case for most people, you will most likely be in a lower tax bracket at retirement when you start making withdrawals from your RRSP. Therefore, you will pay less in taxes than you otherwise would have during your peak working years.

This tax-saving and retirement-enriching wonder account is definitely worth a thought (or two!).

If you enjoyed this article or have any questions, please leave them in the comment section below! I’d love to hear from you! Also, please feel free to share this with anyone that may benefit from it.

“Our goals can only be reached through a vehicle of a plan, in which we must fervently believe, and upon which we must vigorously act. There is no other route to success.” 

–Pablo Picasso

RRSP

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TAKE CONTROL OF YOUR PERSONAL FINANCES

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Ever feel like money just seems to slip through your fingers month after month? Our Monthly Budget Tracker will guide you to start making the most of every dollar. It’s a game changer—get it free for a limited time!

Nikki Kirimi

Nikki Kirimi is a finance professional (MBA, CPA, CMA) and the creator of Money World Basics. She enjoys acquiring and sharing personal finance knowledge to help people better their lives.