More than sixty years after the federal government introduced the Registered Retirement Savings Plan as a vehicle to save for the future, RRSPs still remain one of the cornerstones of retirement planning for Canadians.
In fact, as employer pension plans become increasingly rare, the ability to save inside an RRSP over the course of a career can often make or break your retirement.
Here’s a beginner’s guide to RRSPs:
The deadline to make RRSP contributions for the 2022 tax year is March 1, 2023.
Anyone living in Canada who has earned income can and should file a tax return to start building RRSP contribution room. Canadian taxpayers can contribute to their RRSP until December 31st of the year he or she turns 71.
Contribution room is based on 18% of your earned income from the previous year, up to a maximum contribution limit of $29,210 for the 2022 tax year, and $30,780 for the 2023 tax year. Don’t worry if you’re not able to use up your entire RRSP contribution room in a given year – unused contribution room can be carried-forward indefinitely.
Keep an eye on over-contributions, however, as the taxman levies a stiff 1% penalty per month for contributions that exceed your deduction limit. The good news is that the government built in a safeguard against possible errors and so you can over-contribute a cumulative lifetime total of $2,000 to your RRSP without incurring a penalty tax.
Find out your RRSP deduction limit on your latest notice of assessment or online using CRA’s My Account service.
You can claim a tax deduction for the amount you contribute to your RRSP each year, which reduces your taxable income. However, just because you made an RRSP contribution doesn’t mean you have to claim the deduction in that tax year. It might make sense to wait until you are in a higher tax bracket to claim the deduction.
When should you contribute to an RRSP?
When your employer offers a matching program: Some companies offer to match their employees’ RRSP contributions, often adding between 25 cents and $1.50 for every dollar put into the plan. Sadly, many Canadians fail to take advantage of this “free” gift from their employers – giving up a guaranteed 25-to-150% return on their contributions.
When your income is higher now than it’s expected to be in retirement: RRSPs are meant to work as a tax-deferral strategy, meaning you get a tax-deduction on your contributions today and your investments grow tax-free until it’s time to withdraw the funds in retirement, a time when you’ll hopefully be taxed at a lower rate. So contributing to your RRSP makes more sense during your high-income working years rather than when you’re just starting out in an entry-level position.
Related: A sensible RRSP vs. TFSA comparison
A good rule of thumb: Consider what is going to benefit you the most from a tax perspective.
When you want to take advantage of the Home Buyers’ Plan: First-time homebuyers can withdraw up to $35,000 from their RRSP tax free to put towards a down payment on a home. Would-be buyers can also team up with their spouse or partner to each withdraw $35,000 when they purchase a home together. The withdrawals must be paid back over a period of 15 years – if not, the amount is added to your taxable income for the year.
*Note, watch for the new First Home Savings Account coming later this year, an account that allows you to contribute up to $8,000 per year to a lifetime limit of $40,000. Contributions are tax deductible, and withdrawals are tax free if used to purchase a qualified home.
When you want to increase your Canada Child Benefit payments: An RRSP contribution reduces your net income, a measure which is used to determine how much parents will receive from the Canada Child Benefit program. These tax-free benefits are reduced or phased-out at certain income thresholds. Young families should consider making an RRSP contribution to lower their adjusted net family income and get more from the Canada Child Benefit program.
Beware of raiding your RRSP early
Unless it’s a dire emergency then it’s generally a bad idea to withdraw from your RRSP before you retire. For starters, you have to report the amount you take out as income on your tax return. Not to mention you won’t get back the contribution room that you originally used.
To make matters worse, your financial institution will hold back taxes – 10% on withdrawals under $5,000, 20% on withdrawals between $5,000 and $15,000, and 30% on withdrawals greater than $15,000 – and pay it directly to the government on your behalf. That means if you take out $20,000 from your RRSP, you’ll not only end up with just $14,000 but you’ll have to add $20,000 to your income at tax time.
What kind of investments can you hold inside your RRSP?
A common misconception is that you “buy RRSPs” when in fact RRSPs are simply a type of account with some tax-saving attributes. It acts as a container in which to hold all types of instruments, such as a savings account, GICs, stocks, bonds, REITs, and gold, to name a few. You can even hold your mortgage inside your RRSP.
Related: 5 common myths about RRSPs
If you hold investments such as cash, bonds, and GICs then it can make sense to keep them sheltered inside an RRSP because interest income is taxed at a higher rate than capital gains and dividends.
A good approach, depending on your age and stage, is the tried-and-true balanced portfolio consisting of 60% stocks and 40% bonds. You can achieve this mix with one balanced mutual fund, one balanced ETF, or a couple of low cost index funds or exchange-traded funds (ETFs).
Contributing to an RRSP is simply one of the best ways for Canadians to save for retirement and reduce their tax burden. The RRSP advantage is further heightened when you consider employer-matching programs, access to the Home Buyers’ Plan, and potentially increasing your Canada Child Benefit payments.
The idea is to contribute to your RRSP in your higher income earning years and withdraw from it in retirement, when income is typically lower. Your contributions, invested sensibly, will grow in a tax-deferred manner until retirement, when withdrawals are fully taxable.