RRSPs Explained: Find out if they’re right for you

This article was originally published in RBC Direct Investing’s Inspired Investor magazine.

As a Canadian investor, RRSPs have likely been on your radar for a very long time. They have, after all, been around since 1957.

The RRSP, or Registered Retirement Savings Plan, is a key part of many Canadian investment plans — one that can provide many savings incentives and tax advantages when used appropriately. To help you make the most of your RRSP, or determine if an RRSP is right for you, let’s review the essentials.

What Is An RRSP?

An RRSP is a retirement savings account registered with the federal government. The plan is designed to encourage Canadians to save for retirement by providing tax benefits for ongoing, annual savings contributions.

An RRSP is an account, NOT an investment itself. You can buy and sell qualified investments within an RRSP. Here are some of the most common investments that can be held in an RRSP:

• Stocks
• Exchange-traded funds (ETFs)
• Mutual funds
• Options
• Cash and cash equivalents , such as Treasury bills (T-bills)
• Bonds
• Guaranteed Investment Certificates (GICs)
• Gold and silver certificates

Certain types of investments don’t qualify for RRSPs, including things like precious metals, commodities futures and some tangible assets like art, jewels and real estate.

Who Is Eligible?

RRSPs are available to Canadian citizens who have employment income, file tax returns and have a valid Social Insurance Number. There is technically no minimum age requirement for RRSPs, although age-of-majority restrictions can apply in some cases.

There is, however, an age maximum. Investors must close their RRSP by the end of the year they turn 71, meaning the funds must be withdrawn, transferred to a Registered Retirement Income Fund (RRIF) or used to purchase an annuity. Find out more in Getting ready to retire: Maturity options for your retirement savings plans.

What Are the Tax Benefits?

Tax savings are at the heart of RRSPs. When it comes to using your RRSP as part of your investment strategy, it’s important to understand how it affects your current and future tax liabilities. There are three major tax elements to consider as you contribute to your RRSP through the years.

1. Your contributions are tax deductible. When you put money into your RRSP, the same amount is deducted from your taxable income for that year. For example, if you contribute $5,000 to your RRSP throughout the tax year, it decreases your income by $5,000 for that year. In effect, it means your RRSP contributions are made with pre-tax dollars.

2. You don’t pay tax until later. Any income and capital gains you earn on your investments within an RRSP are tax-deferred. This means you will not pay tax on the growth of your investments while they are in your RRSP account.

3. When you do pay tax, it’ll likely be at a lower tax rate. RRSPs are not a “no tax forever” card. RRSPs are designed to encourage Canadians to save more during their peak earning years, which is also when your marginal tax rate is likely the highest. To combat this, RRSPs allow you to pay tax on your contributions and your earnings later in life — ideally after retirement — when your marginal tax rate has likely gone down along with your income. Here’s the ideal RRSP scenario for many: Make tax-deductible contributions and earn tax-free income while your tax rate is highest and pay tax on the savings in the account after you retire and your income/tax rate are lowest.

RRSPs offer other potential benefits as well that will apply to some Canadians but not others. For example, spousal RRSPs allow for a form of income-splitting in the future, homebuyers may be able to borrow from their RRSPs without penalty to buy or build a first home and the Lifelong Learning Plan allows you or your spouse to borrow from your RRSP without penalty for education.

How RRSPs Work

Once you’ve opened an RRSP — which is similar to how you’d open other investment accounts — the investment decisions you make within it are your own.

A few specifics to keep in mind:

• You can contribute up to 18 per cent of your income for the year — up to an annual maximum that is determined by the government (you can find your specific limit on your latest notice of assessment or through the “My Account” portal on the Government of Canada website)
• You have 60 days after the end of the year to make your RRSP contribution for the previous year
• If you are a member of a pension program, annual pension adjustments will affect your contribution limit
• There are penalties for contributing over the limit
• There can be tax implications for withdrawing your money before retirement. For example, you won’t regain the contribution room when you withdraw funds, unlike in a TFSA
• Any unused contribution room is automatically carried forward for you to use in future years
• In the year you turn 71, your options are to withdraw your money in cash, buy an annuity, or convert your RRSP into a Registered Retirement Income Fund (RRIF) to use during your retirement

RRSP or TFSA?

Discussions about RRSPs often include mentions of the Tax-Free Savings Account (TFSA), another registered savings account option available to Canadians. TFSAs are similar in that they are registered accounts that provide tax incentives for Canadian investors. But, they are also different in many ways. The right account or combination of accounts for you depends on your circumstances, goals and investment strategy.

Here are a few key ways TFSAs and RRSPs differ:

• TFSA contributions are not tax-deductible
• TFSA contribution limits are the same for all Canadians rather than being related to your income
• You can withdraw money from a TFSA at any time without penalty and without being subject to tax (contributions to TFSAs are after-tax income dollars). You will also get that contribution room back- amounts withdrawn in one year will be added back to your contribution room at the beginning of the following year
• TFSAs can be used for any savings goal (short- or long-term), while RRSPs are specifically intended for retirement

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