Everything you need to know about Registered Retirement Savings Plans

It’s February – and Registered Retirement Savings Plan (RRSP) season again. What do you need to know to take advantage of the tax savings it offers and maximize this investment?

Here’s a basic primer that can walk you through what it is, and its advantages and disadvantages.

What is a registered retirement savings plan (RRSP)?

RRSPS are one of the major tax shelters available to Canadians. They’re a key way to delay paying your taxes.

Not all Canadian taxpayers are using them, and not all of those who do maximize their contribution to them. So, ask your advisor how to check your my.cra account to see how much you’re allowed to contribute each year – and how much backlog you might  add to that – so that you can take full advantage of your maximum contribution level to save on taxes now and save for your retirement later.

How does an RRSP work?

RRSPs are pretty simple. You contribute money before the end of February each tax year and it grows tax-free until you withdraw it.

When you eventually withdraw your money from it, that sum will be taxed at your marginal tax rate.

You can withdraw your money any time, without paying a penalty, but the tax will be withheld as a pre-payment for your taxes.

Higher-income people like this tool because they can defer their taxes until they retire, when their income is usually lower.

What are the advantages of an RRSP?

RRSPs offer six benefits:

1. Make some withdrawals without paying tax: There are two programs where you can withdraw your RRSP contributions without paying any tax. The first is the Home Buyers Plan, which first-time home buyers can use. The second is the Life Long Learning Program, which those returning to school can use. These programs have limits on withdrawals and require you to repay the money with 15 years. But the programs mean you can make an RRSP contribution, get a tax refund, and then withdraw that money for these programs without paying the tax.
2. Make withdrawals at any age: One of the big benefits of having an RRSP is that you can make withdrawals anytime before you retire, which is great for early retirees. A similar fund in the U.S. – the 401K – does not allow that.
3. Contributions are tax-deductible: If you make an RRSP contribution, you get a tax deduction, which will lower your net income. That can increase your income-tested government benefits.
4. Creditor protection: Not everyone knows this, but RRSP savings are protected from creditors. This includes lawsuit or bankruptcy claims. Tax-free savings accounts and Registered Education Savings Plans don’t have this benefit, so their funds can be seized to cover personal liabilities.
5. Tax-free compounding: RRSPs are the only investment where you can grow your money tax-free. That means your investment will compound much faster than if it was taxed. This can add up significantly over the years, so you can grow your retirement fund faster inside an RRSP.
6. Lower your lifetime tax rate: RRSPs allow you to lower your average lifetime tax rate. You can make contributions during high-tax years and withdrawals in low-tax years. That can add up to a lot of savings over time.

What are the disadvantages of an RRSP?

RRSPS have seven disadvantages:

1.  All withdrawals are taxed: Any money that you put into your RRSP can be taxed at your marginal tax rate when you withdraw it. Dividends from Canadian companies and capital gains receive special tax treatment if they’re not in an RRSP, but they don’t if the funds are in an RRSP.
2. Withdrawals impact income-tested benefits: RRSP withdrawals can impact government benefits when you retire, so your Old Age Security or Guaranteed Income Supplement may be clawed back. You can lose up to half of those benefits, depending on your tax category.
3. Limited contribution room: If you withdraw some money from your RRSP, you can never get that contribution room back again.
4. Income-based contribution room: The amount you can contribute to your RRSP is based on your gross income. So, in years where you have less income, you can also make less contributions. Tax-free savings accounts, on the other hand, always allow you to contribute the same amount, regardless of your income.
5. Less flexibility to share contribution room: You can only contribute to your RRSP based on your own earned income. Spouses can’t contribute to each other’s RRSP, or they’ll be penalized.  The higher-earning spouse can contribute to a spousal RRSP for the lower-earning one within certain guidelines, but you should ask your advisor about the rules around that.
6. Mandatory withdrawal at age 72: By the end of the year when you’re 71, you must convert your RRSP into an RRIF, which has a prescribed withdrawal rate. These minimum withdrawals must be made, whether you need the money or not. The withdrawal rates climb each year until you’re 95, when they hit 20% of the balance. These mandatory withdrawals can create a tax burden that you have to manage properly to avoid paying unnecessary taxes.
7. Spending your tax refund: If you get a tax refund, you should maximize its impact by putting the money back into your RRSP for the next year – rather than spending it. Ask your advisor about the mathematics behind it, but that can add up to a huge savings for your retirement fund.