What is a Registered Retirement Savings Plan (RRSP)?
A Registered Retirement Savings Plan (RRSP) is a fundamental component of every Canadian's personal finance journey.
As a Government-registered, tax-advantaged account, RRSPs help millions of Canadian citizens plan for retirement while lowering their income tax and maximizing savings and investing potential.
While RRSPs have a place in every Canadian financial planning strategy, the account can be a little tricky to understand and use properly.
That’s why, in this Wealth Rocket guide, we'll explore RRSPs, how they work, how to use them properly, their benefits and drawbacks, and more.
Table of Contents
What is a Registered Retirement Savings Plan (RRSP)?
A Registered Retirement Savings Plan (RRSP) is a savings and investing account primarily purposed for retirement planning. It is an account registered with the Canada Revenue Agency (CRA).
As a retirement planning tool, an RRSP is an account designed to receive regular contributions throughout your entire lifetime, until retirement, when it's the ideal time to withdraw.
RRSPs can hold cash savings and various investments, including cash, Guaranteed Investment Certificates (GICs), stocks, mutual funds, Exchange-Traded Funds (ETFs), bonds, and other investments.
RRSPs are tax-advantage accounts that come with a yearly contribution limit, known as an RRSP Contribution Limit. The RRSP limit is either 18% of the income you've earned or $27,830 in 2021, whichever is lower. The contribution limit increases each year automatically.
Your RRSP Deduction Limit is unused contributions with your available contribution room.
Canadians can open an RRSP as soon as they have a Social Insurance Number (SIN).
How Does a Registered Retirement Savings Plan (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 placed in such accounts aren't easily accessible. That said, money in an RRSP is meant to sit for many years or decades.
RRSPs do not permit tax-free withdrawals, but instead defer taxes to a later year when the account holder decides to retire.
Simply put, contributing to your RRSP today will help you save on taxes this year. Taxes are charged when you withdraw them at retirement.
You are legally allowed to withdraw savings or investments from your RRSP account before retirement. However, you will face some tax penalties depending on the amount you withdraw beforehand. This is known as the RRSP Withholding Tax. The contribution room for the amount you've withdrawn isn't replaced, either.
RRSP withdrawals are taxed accordingly:
- $5,000 or less: 10%
- $5,001 to $15,000 20%
- $15,000 or more: 30%
In Quebec, the RRSP withholding tax is:
- $5,000 or less: 20%
- $5,001 to $15,000 25%
- $15,000 or more: 30%
It goes without saying that an RRSP is an important aspect of every Canadian's financial journey.
Canadians can contribute to an RRSP until the age of 71. Your RRSP will then turn into a Registered Retirement Income Fund (RRIF) when you are ready to retire. You will then pay taxes on your RRIF withdrawals.
With consideration to the limitations surrounding an RRSP, it is important to familiarize yourself with a Tax-Free Savings Account (TFSA) or Emergency Funds before contributing all of your money into an RRSP.
How to Set up a Registered Retirement Savings Plan (RRSP)
Setting up an RRSP is a straightforward process. You'll first and foremost have to decide if you'll want to invest or save.
If you want to go the route of traditional savings, you can open an RRSP savings account through a traditional bank, independent bank, or credit union. Traditional savings are safer but offer lower returns.
If you want to take the RRSP investing route, things get a little more complex:
- RRSP Bonds act as loans between the investor and the borrower, which is often a government or a company. RRSP Bonds are purchasable through banks and other financial institutions.
- RRSP ETFs are a type of security that follows an index and is sold on a stock exchange. Think of it as a basket of investments, chosen carefully on your behalf. Since it is traded on an exchange, ETFs are subject to fluctuating prices. Depending on your risk tolerance, prices can change a lot or very little. You can purchase RRSP ETFs through a robo-advisor and an online brokerage.
- RRSP Mutual Funds combine various investments into one portfolio, managed by a portfolio manager.
- RRSP GICs are term investments that act almost exactly like savings accounts. The difference is that the money is inaccessible, meaning that if you choose to retire, you won't be able to use your money until the GIC reaches maturity.
- Stocks are shares of a company that are typically purchased through a traditional brokerage or online brokerage.
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.
An RRSP 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.
Our Final Thoughts
RRSPs are absolutely fundamental if you want to build a solid financial portfolio as a Canadian citizen. The earlier you start saving or investing with one, the better.
While nothing in life is totally free, an RRSP comes very close to that statement. The more you invest, the more you can save on your taxes while saving up for a home, education, or your eventual retirement.
Compound interest words best as soon as possible. So, don't wait! Start investing an amount that works for you today.
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.