A Registered Retirement Savings Plan (RRSP) is an investing and savings account that allows you to grow your money with tremendous tax benefits. RRSPs can hold a number of qualifying investments, including stocks, bonds, and mutual funds, and because your money grows tax-free, it can be a powerful way to take advantage of compound growth.
Though they have contribution limits and withdrawal rules, RRSPs are pretty simple to understand and use. If you’re considering opening one for your investments, here’s what you need to know.
What is an RRSP?
A Registered Retirement Savings Plan (RRSP) is a government-sponsored retirement account that allows you to save money for the long-term, while also taking advantage of certain tax breaks. You can open an RRSP at most financial institutions, including banks, credit unions, trusts, and insurance companies, or your employer may offer a company-sponsored RRSP (called a “Group RRSP”), often with a contribution match.
With an RRSP, you save on taxes in two big ways. First, any contributions you make can be deducted off your taxable income, up to your contribution limits (more on contribution limits below). For instance, if you make $60,000, and you contribute $5,000 to your RRSP during the year, then you can deduct $5,000 from your taxable income and pay taxes on $55,000.
Second, your investment gains are tax-deferred. That means, no matter how much your investments grow, you won’t pay capital or dividend gains to the CRA, at least not for now. The only time you pay taxes is when you withdraw money from your RRSP in retirement. At that point, each withdrawal you make will be taxed at your marginal tax rate, which, if you’re retired, will most likely be lower than the tax rate you have now.
How does an RRSP work?
Every year, income-earning Canadians between the ages of 18 and 71 can contribute to their RRSPs up to the maximum amount. The contribution limit is either 18% of the previous year’s earned income or an amount specified by the CRA, whichever is less (for 2021, that amount is $27,830).
For example, if you made $100,000 last year, you can contribute up to $18,000. On the other hand, if you made $250,000 last year, then you would only be able to contribute the CRA’s imposed maximum, $27,830 (18% of $250,000 would be $45,000).
Contributions are taken directly from your paycheque pre-tax (without being taxed) and added to your RRSP. Once you have funding in your account, you can hold it in a variety of accounts and investments, including:
- Exchange-traded funds
- Mutual funds
- Index funds
- Savings accounts
- Guaranteed Investment Certificates (GICs)
- Income trusts
- Gold and silver
What happens if you can’t contribute the maximum within a given year? Easy — the extra space rolls over into the next year.
For example, let’s say your maximum contribution for both 2021 and 2022 is $18,000. Let’s also say you contributed $6,000 in 2021, leaving you with $12,000 of unused space. That $12,000 will roll over into 2022. That means, during 2022, you can contribute $30,000 ($18,000 plus the unused $12,000). Unused contribution space will keep carrying forward like this until you turn 71.
At 71, you have to cash out your RRSP, turn it into an annuity, or convert it into a Registered Retirement Income Fund (RRIF). A RRIF is basically an annuity contract that will give you periodic payments until you run out of RRSP funding or you pass away.
What happens if you over-contribute to an RRSP?
The Canadian government frowns upon over-contributions, though they’re not extremely harsh with punishments.
You can typically contribute $2,000 over your maximum limit with no penalties. After $2,000, you’ll get several notices from the CRA asking you to withdraw your excess contribution. Fail to withdraw the appropriate amount, and the CRA will charge a 1% penalty per month on the excess.
For instance, if you’re $5,000 over your maximum, you’ll pay $50 per month ($600 per year) until you withdraw the $5,000.
Can you make early withdrawals from an RRSP?
RRSPs can be a great savings vehicle. But, if you withdraw before you turn 71, you could get hit with several taxes.
For one, you’ll pay a withholding tax on the amount you’re withdrawing. More than likely, you won’t pay this directly: your RRSP provider will deduct the necessary portion from your withdrawal and pay the government on your behalf. Unless you live in Quebec, here’s what you can expect to pay:
- 10% tax rate: withdrawals up to $5,000
- 20% tax rate: withdrawals between $5,000.01 and $15,000
- 30% tax rate: withdrawals greater than $15,000
On top of this withholding tax, you’ll also need to report your withdrawals as income on your tax filings. The more you withdraw, the higher your taxable income and the more you’ll pay in taxes for that year.
As if that wasn’t enough, you’ll also lose contribution room equal to the amount you withdraw. While you can still make the maximum contribution to your RRSP, you won’t be able to recontribute any early withdrawals. This is different from a TFSA, which allows you to replace what you withdraw.
Finally, keep in mind: withdrawing money means missing out on compound growth. The best way to build substantial wealth is to leave your retirement money invested for the long-term. Even a small withdrawal could come back to haunt you. For instance, if you withdrew $5,000 from an account that had a 8% return, then after 20 years you’d lose out on $19,634 in earnings.
Are there any early withdrawal exceptions?
Yes. Fortunately, the Canadian government isn’t completely merciless on early withdrawals. While you can’t withdraw from an RRSP for just anything, you can withdraw for two very important expenses: buying your first home (the Home Buyer’s Plan) and paying for continued education (Lifelong Learning Plan).
The Home Buyer’s Plan
Under the Home Buyer’s Plan, you and your spouse can withdraw up to $35,000 each from an RRSP without paying taxes. As long as you use the RRSP money as the down payment on your first home, you won’t be penalized for making an early withdrawal.
But there’s a catch — you and your spouse must repay what you borrow within 15 years. Typically, each year the government will require you to repay 1/15th of what you borrowed. If you don’t repay it, the CRA will include it as RRSP income on your taxes (they’ll squeeze the money out of you one way or another).
So long as you can repay what you borrow, you can use $70,000 from multiple RRSPs to help buy your first home.
Lifelong Learning Plan (LLP)
The Canadian government will also allow you to withdraw money tax-free if you’re using it to pay for full-time education or training.
Yes — in order to be eligible for the LLP, you must be enrolled full time (unless you’re disabled, in which case you can be enrolled part-time).
Under the LLP, you can withdraw up to $10,000 per year for a maximum of $20,000. You can withdraw money for a maximum of four years, but anything you withdraw must be repaid in 10 years. Like the Home Buyer’s Plan, the Canadian government will require you to pay at least a tenth of what you borrow each year, though you can pay more than that without penalty.
What’s the difference between an RRSP and TFSA?
RRSPs are only one type of government-sponsored retirement account. The other most popular account is the Tax-Free Savings Account (TFSA), which works similarly to RRSPs: each year, you have certain contribution limits, and any contributions can grow tax-free within the account. But, beyond that, TFSAs and RRSPs have some key differences.
For one, TFSAs have more flexible withdrawal options. Whereas an RRSP only lets you make tax-free early withdrawals for buying your first home or paying for full-time education, a TFSA allows you to make early withdrawals for, well, pretty much anything. Your TFSA is a savings account, which means you can use it to save up for a car, a vacation, a new laptop, or, yes, even your retirement.
Secondly, with a TFSA, you don’t pay taxes on withdrawals. Again, this is different than a RRSP, which uses pre-tax money (money in your paycheque that hasn’t been taxed), then taxes you later. A TFSA, on the contrary, uses after-tax dollars: you’ve already paid taxes on your contributions, so the CRA won’t tax you again later.
Lastly, the contribution limits on TFSAs are typically much narrower than an RRSP. For example, the maximum contribution limit for a TFSA in 2021 is $6,000, which, depending on how much you make, can be significantly less than the 18% limit on RRSPs.
Is an RRSP right for you?
An RRSP is an excellent retirement vehicle, and you should definitely use one to save for your retirement. The tax-deferred benefit on RRSPs will help you earn more money in your investments, and as long as you don’t make illegal withdrawals (or over-contribute), you’ll save a hefty sum on your tax bill, too. By opening an RRSP early, and by contributing frequently, you can sock away a hefty amount for your golden years.