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Chances are, if you haven’t used a registered retirement savings plan (or RRSP for short) you know someone who has. That’s because the RRSP is a staple of Canadian savings, and it has been since its inception in 1957. You often hear about people making contributions themselves at the bank, through their employers, making the RRSP deadline, or maxing out their RRSPs.
What do any of these statements mean, and how are they significant? Are RRSPs even as good as they appear to be? To get the answer to these questions, we must understand its technicalities. So, here are 7 facts about RRSP that you need to know.
1. What is an RRSP?
An RRSP is a type of registered account which was created by the government to encourage people to save for retirement. As an incentive, it provides special tax benefits which we go into later in the article.
You can open up an RRSP account at almost any financial institution such as banks, investment firms, and insurance companies. Another decision you’ll have to make is what sort of investment you want to put into your RRSP. It can simply be a savings account or a GIC. You can also invest in stocks, mutual funds, and many other options. Regardless of the investment, you’ll receive the same tax benefits simply because the investment is held within an RRSP account.
2. RRSP contribution room is based on your working income
Your contribution room is calculated by taking your earned income and calculating 18% of that, resulting in your total contribution room for that year. Someone who made $50,000 in working income in 2017, would have a contribution room of $50,000 x 18% = $9,000, for instance.
Earned income is your working income or self-employed income, excluding investment income or dividend income. For the difference in income types and how they’re taxed, please take a look at our article here.
3. There is a max annual contribution limit which changes every year
The idea is that if someone makes quite a bit of money, they can’t have unlimited contribution room!
4. The contribution room you earn is cumulative
If you don’t use your contribution room this year, you don’t miss out on anything, because it will add up to your total lifetime contribution, and you can use that room next year. Some people can have hundreds of thousands of contribution room in their RRSP just because they’ve never contributed to it, for example.
5. Any RRSP contribution grants you a tax deduction
This is one of the main reasons why people love the RRSP: any contribution you make is tax deductible. Using the previous $50,000 income example, if they made a $5,000 contribution, they would have a taxable income of only $45,000. This can make a big difference on their taxes, as they effectively save taxes on $5,000 worth of income, which would be roughly $1,500 of real dollars!
6. An RRSP is a tax shelter, growing tax deferred
Typically, when you have a regular investment, you are taxed by the end of every year. On the other hand, a tax-sheltered investment such as the RRSP, don’t get taxed until you decided to withdraw the money. At that time, you would pay taxes on whatever amount you choose to withdraw. The idea is that when you’re retired, you are typically earning less money, which means the income you take from your account will be taxed at a lower rate.
If you have a good planning for retirement, it’s possible to actually earn just as much in retirement as you did while working. Some people even run into an issue of not wanting to withdrawal money from their RRSP, because they fear massive tax repercussions.
7. If you don’t empty your RRSP by age 71, it gets converted to a registered retirement income fund, or RRIF
If the money sits in an RRSP perpetually, the government will never be able to tax it. Because of that, there’s a rule in place which converts a RRSP to a RRIF. The RRIF forces people to withdrawal the money at a pre-determined rate set by the government. By age of 90, all the money will be withdrawn and as you may have guessed, the withdrawals are fully taxable.
Now that you’re armed with this knowledge about RRSP, we encourage you to read about any other savings and investment vehicles you might want to use to put together the best financial plan for yourself!
Finjoy Capital is not a financial advisory firm.
This article is for informational purposes only and is not a substitute for individualized professional advice.
