You’ve likely noticed by now a ton of ads for RRSPs. This is pretty typical from the banks since the end of February is the deadline for contributions for the previous tax year. This is a great reminder for everyone, but RRSP contributions can be made any time during the year so there’s no need to panic.
For many people, RRSPs feel like a foreign language. They have no idea what it stands for or how the account works. Heck, many people struggle to manage their monthly expenses so thinking about their retirement savings may be the last things on their minds. Regardless of what your current financial situation looks like, it’s in your best interest to understand how an RRSP works and how you can take advantage of it.
What is an RRSP?
Registered Retirement Savings Plan is the formal name but it’s not very sexy so we all refer to it as an RRSP. Despite what you may have been told or been led to believe you don’t buy an RRSP. Our RRSP is actually a savings vehicle and we’re allowed to put just about any investment we want in there such as ETFs, mutual funds, stocks, and bonds. RRSPs are exclusive to Canada and they’re registered with the Canadian Revenue Agency (CRA) which is how you get a tax break.
Don’t worry if you’re a new immigrant or not a Canadian citizen, as long as you’ve filed a tax return with the Canadian government you’ll be allowed to make RRSP contributions the following year. If you plan on retiring in Canada, then you’ll likely want to set up an RRSP.
The biggest advantage of an RRSP is the immediate tax refund. This is the main reason why people love using their RRSP to save. When you make an RRSP contribution, the government allows you to deduct this amount from your total income for the year which in return gives you a tax refund. Let’s say you earn $45,000 a year, your company would deduct taxes for the CRA based on that amount. If you made an RRSP contribution of $3,000 you would only be taxed at a total income $42,000 ($45,000 – $3,000) because we’re allowed to deduct that contribution. For many people on a salary, you’ve already paid taxes on that income so there’s a good chance you’ll get a refund from the CRA.
As you can imagine, using your RRSP contribution room can be handy for people who have just crossed the threshold into a higher tax bracket. Your RRSP contributions could put you in a lower tax bracket which is great since it means more money in your pocket.
When you hold investments inside your RRSP they are not taxed. It doesn’t matter what you hold in there as their tax implications no longer apply; this is known as a tax shelter. If you hold your investments in a non-registered account you would get taxed based on the type of investment. Interest, dividends, capital gains, etc. they would all be taxed at their normal rates. Although you can invest in many things within your RRSP, not all investments can be purchased within your RRSP. For example, you can purchase Bitcoin or penny stocks inside your RRSP.
I know a few of your eyes lit up when you read no tax, but the reality is you will have to pay tax on your RRSP eventually. You only get taxed when you withdraw your money at retirement since it would now be considered income. This is still a good thing though because in theory, when you retire, your income will be lower than in your working years so you’ll be in a lower tax bracket.
RRSP contribution limits
There is a limit to the amount we can put into our RRSP. Our contribution limit is calculated at 18% of our earned income from the previous year. If you made $45,000 last year, you would have earned $8,100 in RRSP contribution room. Also note that there is a maximum every year; in 2013 it was $23,820 but you need to be making some serious dollars if you’re getting that much room. You start accumulating RRSP contribution room as soon as you earn an income and file a tax return reflecting that income. You can find out your personal limit by looking at your latest letter of assessment. Don’t worry about not maxing out your limit every year as any unused room gets carried forward indefinitely.
If you’re not sold on an RRSP yet or you don’t think saving is important, let me introduce you a wonderful thing called compound interest. If you saved $1000 a year starting at the age of 25 your money would grow to $228,116.56 when you retire at 65 based on a 7% annual rate of return. Now if you waited until you were 39 before you started saving that same $1,000 you would only have $77,232.18. Time is the key factor when it comes to compound interest. The more time you have, the more your money will grow.
This is just an introduction to RRSPs so if you need more information check out the CRA website. Also don’t forget your RRSP is just one savings vehicle that you have access to so don’t ignore your Tax Free Savings Account (TFSA) or any kind of company match that may be offered to you especially pensions.