What is a Registered Retirement Savings Plan?
No matter what age you are, you know you’re going to retire from the workforce one day. Whether that’s ten years from now or forty years from now, it’s inevitable – and you should start planning for how that’ll affect your finances, sooner rather than later. In 1957, the federal government launched a specific savings account designed to help us save for our retirements; it was called a registered retirement savings plan (RRSP). Here’s some basic information about how RRSPs work.
What is a registered retirement savings plan?
A registered retirement savings plan (RRSP) is a savings account that allows Canadians to put aside money for retirement in a tax-friendly manner. Every Canadian citizen aged 18 to 70 who files a tax return may open and contribute to an RRSP. Each dollar you contribute is deducted from your taxable income for that year, which reduces the amount of tax you have to pay the government. Depending on how much you earn annually, your contributions could even put you into a lower tax bracket, meaning you’d have to pay even less tax than before. For these reasons, you can see why Canadians are incentivized to save for retirement in an RRSP.
How much can you contribute to a registered retirement savings plan?
Each year, Canadians are permitted to contribute 18% of their income in the previous year (i.e. wages, rental income, research grants and investment income) up to a maximum of $24,9301. For example, if you earned $50,000 in 2014, you’d be able to contribute $9,000 ($50,000 x 18%) to your RRSPs in 2015.
One thing to note is the “year” in which RRSP contributions count is not the same as our usual calendar year. Contributions can technically be made year-round, but the amount you’d enter in your income tax return would be whatever you contributed from March 1 to the last day of February. So, when you file your tax return for 2014, you’d include all the RRSP contributions you made from March 1, 2014 to February 28, 2015.
What are the benefits of using registered retirement savings plans?
There are three main benefits to opening and contributing to an RRSP:
- So long as they are within the maximum amount permitted, your contributions are tax-deductible. The money you put into your RRSP is deducted from your taxable income for that year; this reduces the amount of tax you will have to pay the government, and may even put you into a lower tax bracket, which would save you even more money.
- Investment earnings are tax-free. That includes capital gains, interest and dividend income; this allows you to build up your portfolio over time without having to pay substantial capital gains and interest income tax to the government.
- Contributions and earnings are only taxable when the money is withdrawn from your RRSP. This is beneficial because, for most people, earnings are lower in retirement than they are when the money is contributed. In other words, the contributions and investment earnings are likely to be taxed at a lower rate in retirement than when they were made.
Different types of registered retirement savings plan
There are four basic types of RRSPs:
- Savings account RRSPs: These are just regular (or high interest) savings accounts that are held within an RRSP structure.
- GIC RRSPs: These are just guaranteed investment certificates that are held within an RRSP structure (and deposited for 30 days to 10 years).
- Mutual fund RRSPs: These are mutual funds offered by a financial institution, such as a bank, which are RRSP-eligible.
- Self-directed RRSPs: Setup through a financial institution, such as a discount brokerage firm, these are the “do it yourself” version of the RRSP. They allow you to manage your own portfolio, buying stocks, bonds and mutual funds of your choosing. You should only consider this route if you have both the time and investment expertise needed to build and monitor your investments.
Beyond these four types of RRSPs, you also need to decide if you’re going to open and contribute to an Individual RRSP, a Spousal RRSP and/or a Group RRSP. As an individual, you may open an RRSP for yourself and your contributions are deducted from your personal income taxes. A Spousal RRSP is in your spouse’s name, but you may make contributions for them and still receive the tax deduction. You can also contribute to a Group RRSP, which is a pooled savings plan offered by some employers. With Group RRSPs, contributions are automatically deducted from your paycheque and your employer may match those contributions.
What investments can be held in registered retirement savings plans?
Many different investments can be held in an RRSP. These include:
- Stocks (also called equities), both foreign and domestic
- Exchange-traded funds (ETFs)
- Mutual funds
- Gold and silver bars
- Savings bonds
- Federal and provincial government bonds
- Corporate bonds
- Mortgage-backed securities (a type of bond)
- Canadian mortgages
- Treasury bills
Where can you open a registered retirement savings plan?
RRSPs may be opened at banks, credit unions/caisses populaires, brokerage firms, insurance companies and trust companies. If you already have an account with a financial institution, it is also possible to open an RRSP online.
What happens when you withdraw funds from a registered retirement savings plan?
As mentioned above, one of the advantages of contributing to an RRSP is that your contributions are tax-deductible – but you have to pay tax on them eventually, and that day comes when you decide to make a withdrawal. Whenever you withdraw money from your RRSPs, the amount you take out will be subject to tax at whatever your current tax rate. For example, if you were strapped for cash and needed to make a withdrawal in your 40s or 50s – the years you’re probably making the most money in your career – you’ll be taxed at whatever your marginal tax rate is then. For this reason, it’s important to try and leave the money in your RRSPs untouched until you actually retire, so you’re in a lower tax rate (and therefore get to keep more of your money for yourself).
When can money be withdrawn tax-free?
There are two situations in which you may withdraw money from your RRSP tax-free. The first is when you are buying your first house. In this event, you (plus your spouse) may withdraw up to $25,000 each (up to $50,000 total) tax-free from your RRSP for a down payment, through the RRSP Home Buyers’ Plan. You must, however, repay the amount to your RRSP within 15 years. The second reason you can withdraw money from your RRSP tax-free is if you want to pay for education and training for you or your spouse (but not for your children). Through what’s known as the Lifelong Learning Program, you can withdraw up to $20,000 total (max. $10,000/year) from your RRSP tax-free, but it must be repaid within 10 years.
What happens when you finally retire?
When you turn 71, your RRSP must be terminated or converted into a registered retirement income fund (RRIF) or an annuity. Terminating your RRSP (i.e. withdrawing the full amount) would result in a hefty tax bill, because you’d be taxed at the marginal tax rate associated with the balance of your account (the higher the balance, the higher your tax rate); this means you’d have to give a good portion of your savings to the CRA. RRIFs and annuities, however, provide a steady stream of income during retirement and are much more tax-friendly.
If you’re just beginning to start planning for retirement now, know that RRSPs are not the only savings vehicle to choose from – you can also save for retirement using a tax-free savings account (TFSA). However, while both accounts tax shelter any gains made on your investments, only your RRSPs contributions are tax-deductible. On the other hand, you’ll never have to pay tax when you make a withdrawal from your TFSA. Because they both come with different benefits, many Canadians are confused about which option makes the most sense for them. You can read more about the TFSA vs. RRSP debate on our site.
References and Notes
- $24,930 is the maximum contribution limit for 2015. The maximum contribution limit increases each year, as decided by the Canada Revenue Agency (CRA).