What Is a Registered Retirement Savings Plan?
We’re going to take an in-depth look at RRSPs and explain everything about them from the ground up.
What Is an RRSP?
Let’s start with the absolute basics: RRSP is short for Registered Retirement Savings Account. The “registered” part refers to the fact that it is registered with the federal government. This registered status means that RRSPs are subject to some tax exemptions designed to make saving for retirement easier.
RRSPs Help You Defer Taxes
You may have heard friends and family talking about how their RRSP contributions earn them a refund at tax time, and maybe you want to get in on that action. But before you dive in, it’s important to understand how these refunds work.
When you contribute to your RRSP, those contributions are tax-deductible, meaning you don’t pay tax on any money you put in your RRSP. Because you don’t pay tax on your contributions, you’ll usually end up with an income tax refund.
For example, if you earned $60,000 in one year, and you contributed $10,000 to your RRSP, the government would deduct that $10,000 from your $60,000 income. Your new taxable income is $50,000. Your employer automatically collects enough tax for a $60,000 income, so you’ll receive what you overpaid back as an income tax refund.
The money that you contribute to your RRSP also grows tax-free. You won’t pay any taxes on the interest earned inside this account until you withdraw it. If all of this tax-free talk sounds too good to be true, it’s because the tax-free status only applies to contributions and interest earned. Once you are ready to withdraw money from your RRSP in retirement, your withdrawals are considered income, and that’s when you’ll pay tax on it.
Let’s reiterate: when you withdraw money from your RRSP in retirement, you will pay tax on it.
Because RRSPs defer taxes until retirement, you can minimize your taxes if you contribute to your RRSP during your higher earning years and withdraw the money in retirement when you are in a lower tax bracket.
How Much Can You Contribute?
You can contribute 18% of last year’s earned income, up to a maximum stipulated by the federal government. In 2019, the maximum you can contribute is $26,500. If you don’t use all of your contribution room, you can carry it forward to contribute in the following years. You can check your contribution room in your previous year’s notice of assessment, or through the CRA website.
How Does Contributing to an RRSP Work?
RRSPs are much more flexible than that and can hold different types of assets. Think of your RRSP as a tax-deferred basket, into which you can put:
- Mutual funds
- Exchange traded funds (ETFs)
Everything you put into your RRSP will grow tax-free until you withdraw it in retirement, so most Canadians choose a mixture of higher growth options, instead of just cash.
Who Should Open an RRSP?
RRSPs work best for anyone who is currently earning a higher income than they plan to in retirement.
For example, if you currently earn $80,000, and you estimate your retirement income from your savings will be $50,000 per year, an RRSP is a perfect way to save for retirement and defer taxes to a time when you’ll earn a lower income.
In contrast, if you are newly graduated and earning just $35,000 per year, but you plan to have a $50,000 income in retirement, an RRSP won’t be advantageous to you. Instead, you could consider contributing to a Tax-Free Savings Account.
Other Uses for an RRSP
Home Buyer’s Plan
The Home Buyer’s Plan (HBP) allows withdrawals of up to $25,000 from your RRSP to buy your first home. You can withdraw this money from your RRSP without penalties, but you have to pay it back within 15 years. If you don’t pay the money over the 15-year period, it is considered income and subject to the same 10-30% penalty as a regular RRSP withdrawal.
Lifelong Learning Plan
The Lifelong Learning Plan (LLP) allows you to withdraw up to $10,000 per calendar year or $20,000 total for you or your partner to attend a qualified post-secondary institution. You don’t pay any penalties on the money you withdraw as long as you pay it back within ten years. If you don’t pay back the money you withdrew, that money is considered income, and subject to the same penalties as not paying back the HBP on time.
How to Cash in Your RRSP
If you withdraw cash from your RRSP before retirement, you’ll pay a penalty of between 10 to 30% of the amount you withdraw. This stiff penalty means that aside from the two exceptions above, your RRSP should only be used to save for retirement and you shouldn’t touch that money until you retire.
You must close your RRSP when you turn 71. At that point, you can withdraw money from your RRSP in cash; convert your RRSP to an RRIF; or buy an annuity.
RRSPs are a great way to save for retirement and defer your taxes until you reach a point in your life when you are in a lower tax bracket. You can open an RRSP at a major bank and invest in mutual funds, or through a robo-advisor for a passive investing strategy using ETFs. Whatever you choose, the important thing to remember is that the money isn’t taxed now, but it is when you withdraw it. Be sure to factor that into your retirement calculations, and you’ll be on your way to a well-funded retirement.