The registered retirement savings plan (RRSP) is an account for Canadians to grow their money for retirement. In this guide, I will share the benefits of RRSP, important considerations you need to know and common mistakes people make when it comes to their RRSP account. By learning this, you’ll be able to maximize your RRSP in 2021 in preparation for your retirement.
|Editor’s Note: This article was written by Vancouver based personal finance expert, Thomas Chan, who is a regular contributor on NAI500. If you live in the Greater Vancouver Area have any questions about your RRSPs or other financial matters, feel free to contact Thomas! His contact information is below.
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One of the benefits of RRSP is it helps with taxes because you can grow your money in a tax-free account and it remains tax-free until you take it out. This is beneficial for those who work a regular 9-5 job as you’ll receive a bigger tax return. Yes, you will be taxed when you take it out of the account but a smart investor will know that you should always choose to get taxed later rather than now because of time. Time allows for compounding growth while saving for the tax bill when you do decide to take it out. This is why many call the RRSP a “tax later account”.
Here’s an example of how it works, but always talk to a professional accountant for an exact number for your own situation. If you earn $70,000 per year in the 18% tax bracket, you will have to pay $12,600 in taxes to the Canadian Revenue Agency (CRA). If you put $10,000 of your earnings into an RRSP, your income has now been reduced to $10,000 which lowers your tax bracket to 16%. This drops your taxes owed to $9,600 saving you about $3,000. The higher the tax bracket you’re in, the more beneficial it is to contribute to your RRSP in lowering your taxable income.
In order for RRSP to be worthwhile when it comes to your taxes is knowing where you fit within three tiers. The first tier is for those who have an annual income up to $40,000. The second tier is for those who have an annual income up to $80,000 and the third is for those above $80,000. The higher the tier, the more you should focus on your RRSP to reap in the benefits. If you’re in tier one, you may want to instead focus on your TFSA. Again, a professional accountant will be able to tell you more about where you sit.
A lot of people think because it is called a savings account, they should treat it as a savings account. However, you can hold stocks, bonds and other investments in your RRSP so it’s beneficial to look at your RRSP like an investment account instead. There are no capital gains, interest or any other taxes within the account. Think about it in a way where you put money into your RRSP when your income is high and take it out when your income is low (ie. during your retirement).
There is a time limit for contributing to your RRSP
As of this year, your limit is $27,830 or 18% of your previous year’s income and any unused room can be carried forward to the next year. Here’s an example of this: you made $100,000 in 2020 so your RRSP room in 2021 is $18,000. Income comes from your work income, self-employment income, rental income and more. If you have your business, paying yourself in dividends will not increase your RRSP room for the next year and if you have a pension plan, it will share the same RRSP room.
There is a maximum age limit
Your RRSP will automatically become a registered retirement income fund (RRIF) once you turn 71. RRIF does have a max withdrawal and you will be forced to withdraw a portion along with paying the tax on it.
There is a contribution timeframe
You have one whole calendar year to contribute but the CRA also allows you to use the first 60 days of the year to count towards last year’s contribution up until March 1st. This is why you see banks market this timeframe as RRSP season. If you have extra savings, now is the time to think about how it can lower your tax bill.
There is less flexibility in withdrawal
In comparison to TFSA, RRSP has less flexibility when it comes to withdrawal. TFSA invests after-tax dollars but doesn’t lower your income whereas RRSP is using pre-tax dollars allowing you to lower your income. Any withdrawal of RRSP will be considered income for that year and will be taxed. Also note that withdrawing too much in RRSP may reduce your CPP benefits.
One of the biggest misconceptions about RRSP is many think you cannot take it out until you retire. You can. However there are some downsides to doing so which is having to pay taxes on it and losing your contribution room. There are only two scenarios where you can take out of your RRSP tax-free: when you want to purchase your first home or when you want to go back to school. When you purchase your first home, you can use the Home Buyer’s Plan where you can take out up to $35,000 of your RRSP but return it within 15 years. For your education, you can take out up to $20,000 and return it within 10 years. However, taking it out will reduce the amount of time you have to grow your investments.
The second misconception is that people think your RRSP is an investment, which is incorrect. It is an account that can withhold investments like stocks or bonds. I’ll take a coffee mug as an analogy. You can put water in it, coffee in it or beer in it but it all stays the same. You can open several RRSP accounts but the contribution limit stays the same.
The third misconception is not taking your company’s RRSP offering because you think the money will be locked in for a long period of time. It’s free money and will guarantee 100% return on your contribution so always take it! Even if you leave the company, 9 out of 10 times you are able to transfer it to your own RRSP.
I hope this guide provided you with insight on RRSP. I’ll end with one last tip – if you’re planning on going on maternity leave this year, consider contributing to RRSP before March 1st to lower your taxable income. You can take it out once you’re on mat leave to even out the tax bill.