The acronym RRSP stands for Registered Retirement Savings Account. It is a tax-deferred savings account that is registered with the federal government. It is intended that withdrawals are made only upon retirement when you’re earning less and thus in a lower tax bracket. Yes, you still pay taxes on the funds, but deferring taxation actually puts you at an advantage and here is why:
Deferring taxation means 100% of the money you put into an RRSP can earn interest, capital gain, and dividend income through investments without a portion of it being shaved off by the tax man every year. Your returns are then compounding on each other as your initial investment and ongoing contributions are greater than they would be after-tax.
Here is a simple example:
You initially invest $5,000.00 of before-tax income into mutual fund account RRSP account (yes, you can hold anything inside an RRSP, like a mutual fund, guaranteed investment certificate, and even individual stocks). This seed money could be a bonus from work, for the purposes of this example. Let’s assume your annual mutual fund yield is 5%, year-over-year (high growth fund that never stops giving).
In the RRSP account, your investment balance is $20,722.37 BEFORE taxes. In the non-RRSP account (also referred to as a non-registered account), the account balance is $14,622.01 over the 10-year period. But wait—we mentioned that RRSP accounts still get taxed when you are ready to use the funds at retirement. Instead of the 30% in marginal tax on income being paid on the non-registered account every year (the $1,000 contribution), we now only pay 20% in retirement as our income is less and we are using income-splitting with our spouse.
The RRSP account nearly nets us $2k after taxes in retirement. Now, this is a simple example, but consider that people contribute quite a bit more to their RRSP and even take advantage of employer-matched contributions (which is free money), and you can see the potential for sizeable tax savings.
Claim The Deduction Each Year
The government wants you to save for retirement and incentivizes this by allowing you to claim any RRSP contributions as a tax deduction on your yearly income. This lowers your taxes and can potentially earn you a decent refund.
A spousal RRSP is another type of RRSP that allows couples to split their income. The higher earner will typically contribute to the spousal RRSP and will claim the deduction. The lower earner will then be able to withdraw the funds at a lower tax bracket upon retirement. One important thing to note that if any withdrawals are made within a period of 2 years, the tax is assessed on the contributor.
While RRSP’s are a must-have for financially secure individuals, there is a limit to how much you can contribute to them each year. It is 18% of earned income (wages or bonuses) up to a yearly purchase limit set by the government. For 2022, the limit is $29,210. A person can easily find out their RRSP contribution limit (as well as their TFSA limit) on their Notice of Assessment. Never contributed to an RRSP before? You can carry-forward all unused contribution room, which means most people have quite a bit of money they can put towards an RRSP. Put too much into an RRSP, however, and the government will assess a 2% monthly penalty on the amount that is overlimit. Keep this in mind before dumping your grandma’s inheritance into an RRSP account.
RRSP’s are a Necessity
Government-sponsored programs like Canada Pension Plan and Old Age Security are simply not keeping up with inflation. I’ve spoken to many retirees who barely make ends meet with expenses related to assisted care, prescription drugs, food, and transportation. Without a solid employer pension or RRSP savings, many people are facing uncertainty as they head toward their golden years. It is generally stated that an individual would need about $1 million to retire comfortably in today’s terms. Anyone can open an RRSP account and all that is generally needed is a wet ink or electronic signature to get started. Getting started early (you don’t have to be 18 to setup an RRSP) means your investments will blossom that will provide you peace-of-mind and security throughout your life. You could even access the funds if you really need to (mind the hefty withholding tax).