Registered retirement savings plan (RRSP)

Starting and building a Registered Retirement Savings Plan (RRSP) will likely be one of the most important steps you take in your financial life. There is no better way to reduce your taxable income and save for the future.

What are the benefits of a RRSP?

Investments in an RRSP have 2 big advantages over investments held outside an RRSP:

1. The contributions you make are tax-deferred.

(Most people consider it "saving" tax, but the money is actually taxed when you eventually withdraw it.)

If you contribute to an RRSP, you won't pay tax on that money. For instance, say you make $65,000 per year. If you contribute $5,000 to an RRSP, you can deduct $5,000 from your taxable income for the year. You save the tax you would normally have had to pay on that $5,000.

2. The growth of your money is sheltered from tax while it grows.

Investments inside an RRSP grow without being taxed. That is true, whether the growth is from:

  1. interest,
  2. dividends, or
  3. capital gains

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Why are RRSPs such a powerful tool for saving?

Compare 2 scenarios:

  1. Investing outside an RRSP
  2. Investing inside an RRSP

1. Investing outside an RRSP

Suppose you wanted to invest $5,000 of your salary. Outside an RRSP, you'd first have to pay income tax of up to 46% (depending on your income and province of residence). That leaves you with as little as $2,500 to invest.

You then invest the money in an equity mutual fund. Suppose your money is 100% in stocks, and you earn a 10% pre-tax profit, all of which is in taxable capital gains. Capital gains are taxed at half your marginal tax rate, or 25%. Assume you sold your investment a year after you bought it you would lose a quarter of your profits. This means that you really only made an after-tax return of 7.5%. If you continue to buy and sell investments each year for 20 years, your original $2,500 investment would be worth almost $11,000.

2. Investing inside an RRSP

If you invested $5,000 of your salary in an RRSP (assuming you have contribution room), you would be ahead from the start. You could put the full $5,000 to work, as it wouldn't be taxed.

Once inside your RRSP, any profits you make aren't taxed. If you earn an average of 10% a year in the stock market, you would be able to enjoy a 10% average annual compound return. After 20 years you would have over $33,000. That's 3 times the savings you'd have investing outside an RRSP.

When you eventually take the money out of your plan, it's taxed. For many people, their marginal tax rate is lower when they retire. But even assuming it's all taxed at a 46% marginal tax rate, it would still be worth almost $17,000. That's still over 1½ times the savings you'd have from investing outside an RRSP.

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How much can I put into an RRSP?

The best way to find the answer is to look at your "Notice of Assessment" from the Canada Revenue Agency (CRA). That's the form:

  • the CRA sends you after they've finished processing your tax return
  • that tells you how much you owe the CRA (if you do), or how much your tax refund is (if you're getting one)

The amount you can contribute to an RRSP is based on a percentage of earned income to a maximum that CRA determines each year

So what's earned income? If you're an employee, it's generally your salary -- before deductions. If you are self-employed or are an active partner in a business, it includes any business income.

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When can I make an RRSP contribution?

Any time. As long as you have "contribution room" available. That means you haven't fully contributed all the money you've been allowed to in the past. You can make a lump sum payment, or make regular contributions throughout the year.

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What happens if I can't contribute my full allowable amount?

If you can't contribute the maximum in a year, you keep the right to put that money into your RRSP in the future.

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Can I take money out of my RRSP?

Yes. The money is yours and you can withdraw it whenever you want. But whatever you withdraw is included in your taxable income for that year. So, your RRSP withdrawal would be taxed at your marginal tax rate. This is true even if you're withdrawing dividends or capital gains inside your plan, which normally would be taxed at a lower rate.

But if you're buying a house with the RRSP money, different rules apply.

More information is available on the CRA websiteLink to an external website.

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How long can I have an RRSP?

You have to close your RRSP by the end of the year in which you turn 71. If you choose, you can close it anytime before that.

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What are my options when I have to close my RRSP?

You have 3 choices:

  1. Take the money in cash (and you'll pay income tax on the entire amount in one year)
  2. Use the funds to buy an annuity
  3. Transfer the holdings to a registered retirement income fund (RRIF)

1. Take the money in cash

This is an easy, but costly, move. All the money you withdraw from the RRSP will be taxed in that year. Depending on your marginal tax rate, you could lose up to half your savings to taxes.

2. Buy an annuity

If you use your RRSP savings to buy an annuity, the money isn't taxed at that time. But when you receive payments from the annuity, you'll be taxed when you receive them. An annuity purchased with money from an RRSP guarantees you income for life.

3. Transfer the holdings to a registered retirement income fund (RRIF)

If you move money directly from an RRSP to a RRIF, the money isn't taxed at that time. But when you receive payments from a RRIF, you'll be taxed when you receive them.

A RRIF is similar to a RRSP but is used to give you a steady stream of retirement income, while an RRSP is used to save for your future retirement. You can generally invest in the same types of investments and your money can grow tax-free.

The main difference is you can't make contributions to a RRIF. Instead, you must withdraw a set minimum amount from your RRIF each year. This money, like withdrawals from a RRSP, is taxable like regular income. If you need extra money some year, you can take out more than the minimum. If you withdraw extra money, you risk running out of assets and your income could decrease or end earlier than you want.

You can even use money from your RRIF to buy an annuity at any point to secure income for the rest of your life.

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