A Registered Retirement Savings Plan is a type of account available to Canadians to help them save for retirement. Each Canadian who earns income receives contribution room of up to 18% of your earned income from the previous year, reduced if you are a member of a defined benefit pension plan, that can be used at any time; it does not disappear if unused. If you earn about $151,000 per year or more, you can contribute the maximum yearly amount, which is $27,230 and generally increases by a few hundred dollars yearly. Just the act of contributing to the RRSP has benefits, and you can hold most types of publicly traded investments inside an RRSP, which has further advantages.
These are the two main benefits of investing through an RRSP:
- When you make a contribution, you get a tax deduction equal to the amount you contributed. So, if you contribute $10,000 to an RRSP, you reduce your income for that year by $10,000, and receive a reduction in taxes based on your tax rate – the higher your income, the bigger the reduction.
- While the funds are in the RRSP, you do not pay any tax on capital gains, interest, or dividends. This is known as “tax-sheltering”. This allows the investments to grow more quickly, since the profits are not eaten up by taxes until the money is withdrawn.
However, when you eventually withdraw money from your RRSP, you must pay income tax on any amount withdrawn. For most people, you will earn less money – and thus have a lower tax rate – in retirement, so you will pay less tax overall by using an RRSP.
Using a Spousal Retirement Savings Plan (Spousal RRSP), a higher-earning spouse can pay less tax by investing in the name of their spouse or common-law partner. The high-earner makes the contribution and therefore benefits from the reduction in income for that year and, when the funds are withdrawn at retirement, they are taxed in the hands of the lower-earning spouse – this is a technique known as income splitting.
In the year that the RRSP holder turns 71, they must convert their RRSP to a Registered Retirement Income Fund (RRIF), which means that no new contributions are allowed and they are required to start withdrawing, and paying income tax on, a small percentage of their RRIF assets every year starting the following year (in which they turn 72). The withdrawal rate starts at around 5.5% per year at age 72 and increases yearly, up to 20% at age 94 and beyond; full minimum withdrawal rates are available at Canada Revenue Agency. RRIF holders who have a spouse or common-law partner can also elect to use their partner’s age for calculation of the minimum withdrawal, in order to reduce the size of the mandatory withdrawals.
Money that you contribute to your RRSP is not locked in. You can withdraw it at any time if necessary, but you will have to pay income tax on the withdrawals, and the contribution room used when you made the original contribution is lost – funds in an RRSP are intended to remain there until retirement. However, if you are using money for first-time purchase of a home or for post-secondary education, you can take up to $35,000 or $20,000 tax-free, respectively, as long as you agree to pay back the amount withdrawn over the following several years; there is no tax deduction for the repayments.
For many Canadians, the RRSP is the primary savings account they’ll use to save for retirement. An RRSP for a diligent saver who starts early and puts their money to use by investing, can grow to millions of dollars by retirement.