RRSPs Explained
The Registered Retirement Saving’s Plan, also known as an RRSP, is a retirement account that was introduced by the Government of Canada in 1957. The primary purpose of the RRSP is to promote and incentive taxpayers to save for retirement by providing specific tax benefits to those who contribute to their account. Indeed, having many Canadians reach old age with no savings, no ability to work and relying on government assistance to make ends meet would be a national concern. As such, the RRSP was designed to prevent the same by promoting a lifestyle that financially rewards saving during a taxpayer’s working years.
This blog post will briefly examine the various advantages and functions of the Registered Retirement Saving’s Plan.
How Does it Work?
As mentioned earlier, the RRSP is a retirement savings account where taxpayers can contribute funds into and hold various investments including cash, GIC’s, stocks (equities), bonds, ETF’s and others. The primary tax advantage of the RRSP is that any contributions are made pre-tax and are allowed to grow tax free until withdrawal. In other words, any money you contribute to the RRSP will be deducted from your taxable income for that year, and will only be taxed in whichever later year the funds are ultimately withdrawn.
RRSP Tax Advantages
RRSPs present a tremendous opportunity for savings via tax-deferral. For one, we know that the Canadian tax system operates under progressive rates meaning that higher earned income pays a higher tax (for every dollar earned in that bracket) than the lower-earned income. The idea of the RRSP is to deduct as much taxable income as possible during your working years, presumably when you would be earning in the highest tax bracket, and subsequently pay the deferred tax during your retirement years when you would likely be in the lowest tax bracket.
For example, if Taxpayer A earns $100,000 but contributes $18,000 to their RRSP, his/her taxable income would effectively be $82,000 for that year. If the Taxpayer subsequently withdraws the same amount years later after they retired (assuming $0 income), they would be paying 15% on that amount as opposed to the higher 20.5% and 29% tax brackets.
More importantly, the taxpayer gets to immediately recognize the tax advantage of decreasing their tax burden at present and deferring payment until years later. This is arguably the key differentiating factor between RRSP’s and the Tax-Free Savings Account (“TFSA”), another savings account promoted by the Government of Canada. Despite TFSA withdrawals being ultimately tax free, any contributions made to the TFSA do not reduce the taxpayer’s income by the same amount. Alternatively, RRSP’s withdrawals are considered taxable income, but contributions are considered a tax deduction and effectively will lower the taxpayer’s income.
The other main tax advantage of the RRSP is that investments can grow tax-free until withdrawal. Using the example above, if the taxpayer purchases $18,000 worth of equites which issue quarterly dividends, both the capital gain and dividend income will not be taxed until the withdrawal date. This means that the taxpayer can capture the whole dividend income and use it to purchase more equities or other growth-type investments rather than pay a portion to the CRA. Indeed, by allowing the gains to be tax-deferred, this allows investments inside the RRSP to compound and grow at a much faster compared to just investing in a normal brokerage account.
RRSP Contribution and Deduction Limits
Naturally, there is a limit to how much a taxpayer can contribute to the RRSP annually. The Canada Revenue Agency (“CRA”) typically calculates a taxpayer’s RRSP deduction limit as the following:
- The Lesser of
- 18% of your earned income in the previous year; or
- RRSP limit ($27,830 as of 2020).
Importantly, any unused contribution amounts from preceding years carry forward to the contribution limit. That said, unused amounts do not carry over for deduction limits and the maximum amount is capped at 18% of your income or the RRSP limit. Taxpayers must be careful not to overcontribute as there is tax penalty of 1% per month on contributions that exceed their RRSP deduction limit by more than $2,000.
Additional Factors Regarding Contributions and Withdrawals
The RRSP contribution age limit is 71. After that, the RRSP will either convert to a Registered Retirement Income Fund (“RRIF”) or the full amount must be withdrawn and taxed that year. Taxpayer’s can also withdraw from their RRSP anytime before 71, but the withdrawals will be considered taxable income for that year.
One exception to the above rule is the Home Buyer’s Plan (“HBP”). This program allows eligible taxpayers to withdraw up to $35,000 tax-free from their RRSP to help purchase their first home ($25,000 limit for withdraws before March 2019). This incentive aligns with another one of Canada’s policy objectives of promoting home buying for taxpayers. Nevertheless, any amounts taken out from the RRSP via the HBP must be eventually paid back. In effect, taxpayers looking to purchase a new home can view the $35,000 amount in their RRSP as an interest free loan.
Conclusion
The RRSP is truly one of the few great tax saving accounts the Government of Canada promotes and provides to taxpayers. However, there are complex rules surrounding the application of the RRSP and taxpayers must ensure they do not fall into any pitfalls causing unnecessary financial damage to their accounts. If done correctly, taxpayers will benefit greatly from contributing to the RRSP and even get ahead in purchasing their first new home.
If you need assistance with structuring your RRSP or have any general inquiries, contact us today. Professionals at R&A Tax Law have years of experience developing effective tax planning structures specifically tailored to each individual taxpayer. We’re here to help!
**Disclaimer
This article provides information of a general nature only. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in this article. If you have specific legal questions you should consult a lawyer.
Kevin Hong
