Registered Retirement Savings Plan (RRSP) accounts were designed to provide an incentive for individuals to set aside money for retirement. These accounts provide a central foundation for long-term saving goals.
What is an RRSP?
A Registered Retirement Savings Plan (RRSP) is a tax-deferred account. This works by deferring taxes until the money is withdrawn in the future. The purpose is to incentivize people to save for their retirement, which the government does by simply saying, save now, and don’t pay taxes on that money until you need it.
The way this tax-deferral works is by reducing your taxable income for the year by the amount of your contributions. For example, if you make $80,000 per year and you invest $10,000 into your RRSP, the government will only take tax as if you earned 80,000 - 10,000 = $70,000. You are therefore receiving $10,000 tax-deferred. That $10,000 will be taxed in the future when you withdraw your money.
Your RRSP may be opened at any time, although some institutions will require you to be the age of majority. Any RRSP account that you own must be withdrawn or converted into an RRIF or annuity when you turn 71.
RRSP’s are offered by a wide range of financial institutions, from banks to credit unions, mutual fund and investment companies, and even life insurance companies. Through these institutions, you may open an RRSP investment account. Once you have an account, you then have further options of where to invest. The below is a list of eligible investments in an RRSP.
Eligible investments for RRSP
- Savings Bonds
- Treasury Bills
- Mutual Funds
- Exchange Traded Funds (ETFs)
- Mortgage-backed Securities
- Income Trusts
- Gold & Silver Bars
What are the Benefits of an RRSP?
The obvious answer here is that your contributions to an RRSP are tax-deferred, meaning you save money on taxes now, with the promise to pay that tax in the future. This works by allowing you to contribute more money to an investment account. For example, assuming your combined tax rate is 30%, and you plan on investing $10,000 pre-tax this year. If you were to invest after-tax, that $10,000 * (1-30%) = $7,000. Instead, by investing in your RRSP, the taxes are paid in the future. This means that you can invest the full $10,000 now, an extra investment of $10,000 - 7,000 = $3,000. That is $3,000 more invested now that can grow over time.
Using the tax-deferral of an RRSP account is especially important when you use your RRSP as an essential part of your financial strategy, allowing you to save taxes overall. For a more in depth look at how you can use different investment options to save taxes, check out our comparison between RRSP vs TFSA.
How Much Can You Contribute to Your RRSP?
Unlike the fixed amount you can contribute to your TFSA annually, the RRSP has an individual contribution limit set as a factor of your income, up to an annual maximum. Your RRSP contribution limit is set by the lower of 18% of your annual income, or an annual maximum set by the government. In 2020, the annual maximum is $27,230.
Any unused lifetime contribution room is carried forward each year. To see how much you can contribute, check out your account with the CRA. Most individuals who have filed in the past couple years will have been prompted to create an online account already, and since you’re reading this online, you probably are tech-savvy enough to have an online account.
Alternatively, your lifetime contribution limit will have been mailed to you (if you still have mailing selected as an option), and you can find this on your RRSP Deduction Limit Statement.
What If You Over-contribute To Your RRSP?
There is a $2,000 safety buffer, allowing you to over-contribute by $2,000 before you will be required to start paying tax. The tax levied on excess contributions is 1% of the excess balance per month.
What if you need to Withdraw?
Contrary to popular belief, there are no explicit penalties to withdrawing from your RRSP. If you withdraw from your RRSP, that money is taxed as income in the year that you withdraw. However, unlike the TFSA, when you withdraw from your RRSP, that contribution room is lost forever. For example, if your lifetime contribution room was $100,000 and you withdrew $15,000 for your wedding. You will pay tax on that $15,000 in the year you withdraw, plus, your lifetime contribution room will drop to 100,000 - 15,000 = $85,000. This lifetime contribution room is lost forever.
There are 2 special cases where that is not the case, the First-time Home Buyers Plan, and Continuing Education. In those special cases, any withdrawals you make must be repaid over a set term. Essentially, you are borrowing from yourself. In these cases, the contribution room is not lost, but future contributions will be applied to the loan and hence not tax-deductible.
Advanced: Deferring Your Tax-Deferral
You don’t need to claim your tax credit in the year that you make a contribution. In this case, you will essentially be putting after-tax dollars into your RRSP, similar to how you would a TFSA. Those “Unused RRSP Contributions previously reported and available to deduct” will show up on your RRSP Deduction Limit Statement.
You may choose to do this if you expect to be in a higher income bracket in the future. This will mean you can still invest in your RRSP accounts now, and take advantage of investment growth, while saving the tax break for when you are earning more in a higher tax bracket.
What this all means for you
The RRSP is an essential investment account for every Canadian. The tax-deferral properties give this type of account a big leg-up over traditional investment accounts. By saving on taxes now, you are able to contribute more, and let those investments grow over time. The taxes are then paid when you start withdrawing money.
If financial freedom is in your life’s plans (it should be), the RRSP is an essential tool to help you on your journey.