Registered Retirements Savings Plans (RRSP) were introduced in 1957 by the government as an alternative vehicle Canadians could use to save for retirement. Essentially it is an account that is to be used as a long-term savings plan, with the “registered” designation implying that the CRA treats funds that are deposited or “contributed” to an RRSP differently when calculating personal income tax. Funds held within an RRSP may be invested into securities, bonds, ETFs, GICs, REITs and mutual funds. These investments can be self-directed or professionally managed.
The key benefit of contributing to an RRSP is that income tax is not applied to the contribution for that year. It is deferred until it is withdrawn, at which point it is taxed. While you will still be paying taxes on that income, you will likely be in a lower tax bracket upon retirement. In which case deferring the taxable portion of that income by contributing it to an RRSP while you are working and in a higher tax bracket allows you to pay less tax on the income when it is withdrawn at a later time in a lower tax bracket.
Previous and current tax rates can be found at www.canada.ca.
How does an RRSP work?
Setting up an RRSP can be done through a bank or other financial institution. The maximum amount you can contribute to an RRSP every year is referred to as the contribution room. You can contribute until Dec 31st of the year you turn 71. The contribution room available in an RRSP is in relation to the amount of employment income reported on your T4. An RRSP contribution is the amount of money added to your RRSP. You may log in to your CRA account at www.canada.ca to see what RRSP contribution room you have available. The contribution room available takes into account the current year’s deduction limit and any unused contribution room from previous years. Once you retire, or at the age of 71, your RRSP is automatically converted into a Registered Retirement Income Fund (RRIF).
The RRSP deduction is the amount of contributions you can apply against your income tax. The deduction limit is calculated based on your prior year’s earned income and any unused deduction room at the end of the prior year. The following is used to determine the maximum amount. It is the lesser of the following two:
- 18% of earned income from the prior year
- The annual RRSP limit.
The annual limit for 2020 is $27,230 and 2021 is $27,830. You receive a deduction from your taxable income equal to the amount of contribution you make into the account for the relevant taxation year. Contributions can be made up until March 1, 2021, for the 2020 tax year. Unused contribution room can be carried over into future years. It is possible to over-contribute to an RRSP. If you overcontribute, you will have to pay a tax of 1% per month on your contributions that exceed the deduction limit by $2,000.
Spousal/Common-law partner RRSPs
You may also make contributions to a spouse or common-law partner’s RRSP. Contribution to these RRSPs can also be made up until Dec 31 of the year that the owner of the RRSP turns 71. You may use all or a portion of your RRSP contribution room to your partner’s RRSP and be able to apply the deduction to your taxes. However, they will be the owner of the plan.
Withdrawing from an RRSP
The RRSP is intended, as the name implies, to be used for retirement income. Since there was a tax deferral on the monies contributed to your RRSP, withdrawals made from your RRSP will be taxed. If the withdrawals are made in retirement, your tax rate will likely be lower and you will therefore pay less tax.
However, there are some exceptions. First-time homebuyers may use up to $25,000 from their RRSP towards the down payment on their first home and will not be taxed on it. This is the Home Buyer’s Plan (HBP). The other is the Lifelong Learning Plan (LLP). Withdrawals of up to $10,000 a year or up to $20,000 total can be made to pay for you or your spouses’ education. Withdrawals under the LLP must be repaid.
RRSPs are a valuable savings and investment vehicle. They have some competition when it comes to the Tax-Free Savings account (TFSA), but they do offer benefits to savings strategies. Both in terms of short-term savings in the form of tax deferral which may result in refunds on annual tax returns and in terms of long-term growth. RRSPs are an asset to any Canadian looking to retire.