Saving for retirement: What is an RRSP and how does it work?
As a Government-registered, tax-advantaged account, RRSPs help plan for retirement, while deferring income tax and maximizing savings and investment potential.
The RRSP has a place in every Canadian financial planning strategy. That said, the account can be a little tricky to understand and use properly. So, you ask, what is an RRSP, and how does it work? Let’s break it down like Rascalz, Checkmate, Kardinal and Thrust on 1998’s smash Northern Touch. They probably all own RRSPs.
What is an RRSP?
A Registered Retirement Savings Plan (RRSP) is a savings and investing account purposed for retirement planning. It is an account registered with the Government of Canada and supervised by the Canada Revenue Agency (CRA).
As a retirement planning tool, an RRSPs is an account designed to receive regular contributions throughout an entire lifetime until it’s time to retire. They can hold cash savings and various investments, including Guaranteed Investment Certificates (GICs), stocks, mutual funds, Exchange-Traded Funds (ETFs), and other investments.
RRSPs are tax-advantage accounts that come with a yearly contribution limit, known as an RRSP contribution limit.
Moreover, there is a limit to how much one can deduct from their yearly marginal tax rate (RRSP deduction limit).
The contribution limit increases each year automatically.
Canadians can open an RRSP as soon as they have a Social Insurance Number (SIN).
How does an RRSP work?
An RRSP works like any regular savings account but comes with a few conditions, mainly concerning withdrawals and taxes.
Savings or investments placed in an RRSP is known as “sticky money.” The term connotes that funds in such accounts should remain unwithdrawn for long-term financial planning – not Canadian Tire Money that you forgot about and ends up stuck to your old Second Cup loyalty card.
RRSPs do not permit tax-free withdrawals, but deposits into an RRSP defer taxes to a later year when the account holder is in a lower tax bracket.
RRSP withdrawals are taxed accordingly:
- $5,000 or less: 10%
- $5,001 to $15,000 20%
- $15,000 or more: 30%
In Céline Marie Claudette Dion’s province of Quebec, the RRSP withholding tax is:
- $5,000 or less: 20%
- $5,001 to $15,000 25%
- $15,000 or more: 30%
RRSPs come with a yearly contribution limit, which is 18% of the total earned income for the previous year or the yearly amount set by the CRA, whichever is less. Unused room for contributions to an RRSP carries over for previous years since opening it. Canadians can contribute to an RRSP until the age of 71. The accounts then turn into a Registered Retirement Income Fund (RRIF). And like everything in this world, you will also pay taxes on an RRIF withdrawal. Any withdrawn amount in the contribution room disappears forever, making it a precious commodity like gold or maple syrup.
Additionally, cash deposits and GICs in an RRSP come with insurance. Schedule 1 banks come with insurance provided by the Canada Deposit Insurance Corporation (CDIC). Finally, credit unions come with provincial insurance. Investments, while protected against insolvency, are not protected against losses caused by the downturns in the economy – which is often like a rollercoaster you didn’t want to ride but are unfortunately stuck on.
How to set up an RRSP
Setting up an RRSP is a simple and straight-forward process. Understanding how to use RRSP requires a little more consideration.
Since an RRSP can hold traditional cash savings or some types of investments, knowing where to put funds makes a difference in setting up the account. Most financial institutions allow customers to set up an account online or over the phone. If the financial institution has branches, customers can open an account in-person.
For investments, many banks offer RRSP investing options. Other financial services, such as online brokerages, robo-advisors, or independent firms, provide RRSP investing options.
A Registered Retirement Savings Plan can play a big role in your future. Even if you’re nowhere close to retirement age, getting started with an RRSP can set you up for an easy transition into your post-work life.
RRSP Pros and Cons
RRSPs are great accounts to help save for retirement, but not always the best option for every personal finance strategy. Let’s take a look at the advantages and disadvantages of an RRSP.
Pros: The Good Stuff
RRSPs come with several benefits for all Canadians. Here are some pros of using the retirement planning tool.
Tax-deductible: Contributing to your RRSP lowers yearly taxable income. Depending on how much the account holder earns, paying taxes throughout a lifetime significantly impacts a person’s financial wealth. In some cases, the owner of the RRSP may even receive a tax return refund – fun!
Tax-free growth: Investments and savings in an RRSP grow tax-free. Unless prematurely withdrawn, funds in RRSP accounts are not taxable on performance. Using an RRSP is especially useful for investments with high-yielding potential, such as ETFs or stocks.
Cons: The Not So Good Stuff
While necessary, RRSPs are not always the ideal option for all Canadians. Here are some cons to RRSPs.
Taxed on withdrawal: Funds in an RRSP are not accessible at the demand of the investor without penalty. Premature RRSP withdrawals come with an RRSP withholding tax, depending on the amount withdrawn.
Contribution Limits: While RRSPs promote tax-savings on deposits and investments, they come with contribution limits and serious tax-related penalties for over-contribution.
Frequently Asked Questions
Yes. A common misconception about RRSPs is that they only hold cash savings. They also hold a series of additional investments, which include stocks. While an RRSP can’t purchase stocks, they do hold stocks. Individual brokerages, both online and traditional, offer RRSP investing accounts that can hold stocks for tax-free growth. Stocks held in an RRSP can grow tax-free. The deposited amount must remain below the contribution limit, though the actual the stock earnings can exceed the contribution limit.
The RRSP Home Buyers’ Plan (HBP) is a Government-approved program that allows Canadian residents to withdraw money tax-free from their RRSPs to purchase their first home. With the HBP Canadians can withdraw up to $35,000 from their RRSP untaxed to aid in purchasing their first home. People who choose to withdraw from their RRSP through the HBP will not incur taxes, but must recontribute the amount withdrawn back into their RRSP within 15 years of removing the funds. Contribution room will not be affected under the HBP.
Anyone can withdraw deposited funds or investments from their RRSP at any time. However, RRSP withdrawals are subject to taxes. Taxes on RRSP withdrawals are very high, so it’s important to understand that money placed in an RRSP should ideally not be withdrawn before retirement. RRSP deposits defer the year’s taxes to a later date. The owner of the RRSP should withdraw the funds when they find themselves in a lower tax-bracket. That said, RRSP owners can withdraw their funds at their liking, but will incur taxes, unless withdrawn through the HBP or the LLP.
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