Tax Deferred Investing – RRSPs 101
The Registered Retirement Savings Plan (RRSP) has been at the front of helping Canadians save for retirement for decades.
When you think of the RRSP, I think it’s always great to remember RRSPs are a tax deferred vehicle – one of the best we have!
A history of tax deferred investing: RRSP
When the RRSP was created in 1957, contribution limits were 10% of the previous year’s income to a $2,500 maximum. If an individual did not contribute in any given year, that year’s contribution room was gone forever.
Thankfully, things change.
By 1990, contribution limits increased to 18% of the previous year’s income, the dollar limit was raised to $11,500 and the contribution carry-forward rule was introduced, allowing unused room to be carried forward seven years.
In 1996, the government starting indexing the dollar limit to annual wage growth. The pension adjustment (PA) was introduced to level the playing field for contributors with employer pensions and/or deferred profit sharing plans. Around the same time, the seven-year carry-forward rule was scrapped and replaced with an indefinite carry-forward.
The RRSP has competition
A nice addition to tax deferred investing has been tax free investing!
Since 2009, the Tax Free Savings Account (TFSA) has provided Canadians with an outstanding and flexible savings option that avoid taxation on withdrawals whatsoever.
Of course, I still believe RRSPs are great and you should absolutely consider them for your retirement planning purposes.
RRSP facts for any tax year
Fact: your RRSP contribution room is based on 18% of your earned income from the previous year, up to a maximum contribution limit for that tax year.
Read on at CRA about annual tables for: defined benefit (DB), registered retirement savings plan (RRSP), deferred profit sharing plan (DPSP), advanced life deferred annuity (ALDA), tax-free savings account (TFSA) limits, and the year’s maximum pensionable earnings (YMPE).
Fact: the account was designed to encourage long-term savings for retirement.
The taxation of RRSP withdrawals creates a disincentive to use RRSPs for short-term spending needs.
If you need money short-term, including for a house down payment, I personally believe the TFSA or just a savings account is far better.
Fact: the account was designed for tax arbitrage.
Most retirees are in a lower tax bracket during retirement than during their working years.
As a result, the net tax savings (from RRSP withdrawals in a lower tax bracket vs. higher income contribution years) make this account very appealing and powerful.
Fact: the account delivers tax deferred growth.
One of the biggest benefits of this account is tax deferred growth; RRSP assets are not taxed annually like any funds inside a corporation’s taxable account or your personal taxable account. So, using the RRSP for retirement savings and making contributions to your TFSA as well, makes an outstanding 1-2 investing punch.
Fact: you can ignore U.S. tax reporting exemptions.
For U.S. persons living in Canada, RRSPs are exempt from passive foreign investment corporation reporting. For Canadians, under our Canada-U.S. Tax Treaty, RRSPs are recognized as tax deferred accounts for U.S. tax purposes.
Here are more great RRSP facts:
- An RRSP is an account, not a mutual fund or an investment itself.
- Contributions to an RRSP are tax deductible, so you can use these tax deductions to reduce your taxable income.
- Some Canadians shouldn’t use an RRSP (their income may not be high enough (yet) to reap the key benefits of this account).
- RRSPs are highly effective for Canadians who will be in a lower tax bracket in retirement versus their contribution years.
- Contributions to an RRSP for the current tax year do not always have to be made in February.
- There are contribution limits for an RRSP, but most Canadians will have a difficult time reaching their contribution limit year after year after year.
- Contribution limits are based on the contributor’s “earned income” and can be found on his/her tax notice of assessment.
- There are penalties if you over-contribute to your RRSP although a small exemption exists.
- Unused RRSP contribution room can be carried forward, for future tax deductions in future tax years. So, even if you’re in a lower income bracket now consider contributing; just don’t claim the amount for any tax refund. Then, you can take advantage of the tax-deferred growth while saving those tax credits to claim at a future date and time once you make more income. This is a counter-argument to the “RRSPs don’t matter” perspective based on any (lower) earned income.
- Also, a unique thing – unused RRSP contributions have some interesting tax ramifications. You typically deduct your contribution amount on your tax return to lower your tax liability and pay less in taxes that tax year – this is what I do. But….you don’t need to deduct your RRSP contribution on your tax return in the same year you make it. You can choose to take that deduction in a future year. For instance, it may be smarter for you to take the deduction in a year where your income is greater so you fall out of a higher tax bracket. Something to think about!
- After you select investments for the account, the income you earn on those investments inside the RRSP are tax exempt, as long as money stays in the account.
- A common type of RRSP is an individual RRSP, registered in the name of the person contributing to it. There are also spousal RRSPs and group RRSPs.
- RRSPs can be managed by a professional money manager but you can do-it-yourself (self-directed).
- If one spouse is in a different tax bracket than his/her partner, RRSP contributions can be used to lower the total amount of income taxes a couple must pay (income splitting).
- Some people believe you can only have one (1) RRSP account. Not true! There is no limit on the number of RRSPs you can have. The limit is on the total amount you can deduct. However, most people find it simpler to have only one or at most two plans (the second being with their employer-sponsored RRSP) therefore making it easier to keep track of their RRSP investments.
- You’re not as rich as you think: when you take money out of the account, you have to pay tax. Some exceptions apply: RRSPs can be used for home purchases and education and there are programs associated with the RRSP for this.
- There are rules and age restrictions when you must collapse the account. In fact, Canadian taxpayers can contribute to their RRSP right up until December 31st in the year they turn age 71.
- Withholding taxes apply to RRSP withdrawals.
RRSP *withholding taxes:
- If you take up to $5,000, you’re going to pay 10%.
- If withdrawals are between $5,000 and $15,000, the financial institution will hold back 20%.
- If you withdraw more than $15,000, 30% is held back.
You have to report the amount you take out on your tax return as income. At that time, you may have to pay more tax on the money — on top of the withholding tax. It depends on your total income and tax situation.
*Quebec has some different rates for withholding taxes.
These are just some of the RRSP facts.
Tax Deferred Investing – RRSPs 101 Summary
As referenced above, there are two great tax benefits that RRSPs provide Canadian investors:
- a tax deduction today from your RRSP contribution, and
- tax deferred growth.
With your tax deduction, you can reduce the taxes you pay today.
With tax deferred growth, investments in your RRSP can compound over time without being taxed as long as money made stays in the account.
For most Canadians, to reap the benefits of this tax-deferred account they should maximize their contributions where it makes sense (based on their earned income), keep the fees associated with their investments inside the account low and avoid making withdrawals for as long as possible until retirement.
What’s your take on RRSPs? Use them? Maximize them?