An RRSP is a Registered Retirement Savings Plan that you establish, the Canada Revenue Agency registers, and to which you or your spouse or common-law partner can contribute to.
These are some great tax deferred investing concepts you need to know about RRSPs.
- 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.
- 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.
- Withholding taxes apply to RRSP withdrawals.
If you’re taking money out of your RRSP before you retire, you’re immediately going to pay a withholding tax.
- 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.
These are just some of the RRSP facts.
Why RRSPs should matter to you
As referenced above, there are two great tax benefits that RRSPs provide Canadian investors:
- a tax deduction from your 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.
Based on my personal investment plan, I invest using an RRSP. Be careful though – the RRSP-generated tax refund is great but it’s actually temporary; you need to give it back at some point. This makes reinvesting the RRSP refund year after year absolutely critical in my opinion to optimize wealth building – to take major advantage of an essentially a long-term but not permanent government loan.
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.
What’s your take on RRSPs? Use them? Maximize them?