RRSP Tax Deduction
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Contributing to an RRSP is beneficial in a few respects. It allows you to shelter investment earnings from tax so long as the contribution is in the RRSP account. But there’s also a more immediate benefit. Contributing to an RRSP gives you a deduction that saves you money on your income tax. It may even result in you receiving a tax refund.
What happens to your income taxes when you make an RRSP contribution
If you have earned income and file a tax return, the government allows you to contribute money to an RRSP. The contribution limit is 18% of your previous year’s earned income or a specified amount, whichever is less. Any unused RRSP contribution room carries forward indefinitely (use your handy RRSP contribution limit calculator to find how much you can contribute).
The contribution can then be used to lower your taxable income. For example, assume your salary is $55,000 and you make an $5,000 RRSP contribution. We’ll also assume you live in British Columbia, where your combined federal and provincial tax bracket has you paying a marginal rate of 28.2%.
By being able to claim the $5,000 RRSP deduction, you remain in the same tax bracket, but you’ll have lowered your taxable income by the amount contributed. Thus, you would save the following in income tax:
How to use the tax break
RRSPs are not tax-free forever. Rather, they allow individuals to defer paying income tax until they reach the age of retirement and need the money. For most Canadians, their income in retirement will be less than it was when they were working. Hence, they’ll also be subject to a lower marginal tax rate in their golden years. This is why contributing to an RRSP is so advantageous for the vast majority of people. You’re effectively deferring paying income tax on your contributions (and any investment gains) until you’re likely to be paying tax at a lower rate.
When you turn 71
For Canadians who are close to or at the age of 71 and have RRSPs, here are some tips:
- Remember to make your final contribution to your RRSP. You must make this by the end of the calendar year, not the first 60 days of the following year.
- If you’re spouse is younger, you can still contribute to their RRSP
- Take advantage of any unused RRSP room before Dec. 31 of the year in which you turn 71. Once you reach the end of the calendar year, the contribution room will be gone forever.
Your options when you retire
RRSPs don’t last forever. By the end of the calendar year in which you turn 71, you must do one of three things with the money in your RRSP:
- Withdraw the entire amount
- Convert your RRSP to a registered retirement income fund (RRIF)
- Purchase an annuity with the money from your RRSP
Generally speaking, it’s not advisable to just collapse the RRSP and withdraw all of the money. By doing so, you’ll have to pay tax on the whole amount when you next file a tax return. And depending on how large your RRSP is, much of it could be subject to the highest marginal tax rates in your province or territory.
A popular option is to convert the RRSP into a RRIF. In essence, a RRIF is like an RRSP, except that you can only make withdrawals. That is to say, you cannot make any more contributions to the account. The government mandates that you withdraw a certain percentage of your RRIF every year and count the amount withdrawn as income when you file your taxes.
An annuity is a product provided by an insurance company that provides you with a guaranteed amount of income as long as you live. A financial advisor can help you decide what option is best for you.