1. What is a Registered Retirement Savings Plan?
A registered retirement savings plan (RRSP) is an investment vehicle intended to offer investors a way to put up money for retirement and to save on paying taxes today. Unlike a tax-free savings account, the RRSP offers only tax deferral, meaning that investors do not eliminate taxes, but instead postpone them. However, RRSPs could still provide significant tax savings since investors can defer income from their high-earning years when they are taxed at a higher marginal tax rate to their retirement years when they are expected to have lower income and consequently lower tax rate. This way, even if investors are taxed on the same amount of income, the percentage of that income that goes towards paying taxes could be significantly smaller if postponed until retirement.
2. RRSP Contribution Limits
Investors can put up 18% of the previous year’s income* or the RRSP dollar limit for the given year, whichever is less. For 2022, the RRSP contribution limit is $29,210. Thus, an investor who earned $100,000 in 2021 can contribute 18% of that income, or $18,000. However, for an investor who earned $200,000 in 2021, 18% of the income would exceed the maximum contribution limit for the year (18%*$200,000 = $36,000 > $29,210), so the maximum they would be able to contribute to the RRSP would be the $29,210. The annual contribution limit is adjusted for inflation.
The total contribution room limit is comprised of the annual limit and the available room from the immediately preceding year, less the previous year’s pension adjustment (PA) and the current year’s past service pension adjustment (PSPA).
Overcontributions of up to $2,000 do not trigger any tax consequences, but any amount above that would be taxed 1% per month.
There is no limit to the amount of contribution one can make in an RRSP overall, the only limit is the annual contribution. Further, any unused contribution can be carried forward indefinitely.
*The income considered for RRSP purposes includes wages and salaries, net rental income, royalties, disability payments, and certain employment insurance benefits, among others. However, the income does not include employment insurance benefits from Employment Social Development Canada.
3. How to Open an RRSP?
Similar to the TFSA, an RRSP can be opened in various financial institutions like banks, credit unions, trusts, and insurance companies.
4. RRSP Types
There are two main types of RRSP accounts - single vendor plans and self-directed plans.
In a single vendor plan, the account holder invests in various securities like guaranteed investment certificates (GICs) and mutual funds, and the investments are held in the issuing financial institution in a trust. Investors usually pay a trustee fee on top of transaction costs (for buying and selling the investments themselves). In this kind of plan, investors do not make day-to-day investment decisions.
In a self-directed plan, the account holder makes many of the investment decisions by buying and selling assets that are acceptable for such purposes, and decision making is left to the plan holder.
5. Qualified Investments
Many types of assets could be held in an RRSP. They will include money (cash, bank deposits), guaranteed investment certificates (GICs), and shares and debt of publicly traded Canadian companies and foreign companies listed on a prescribed stock exchange. However, investors are not allowed to hold shares or debt of private companies, real estate, commodities, futures contracts, as well as other property like jewellery.
One can also make in-kind contributions by contributing assets they already own. These assets will be deposited at their fair market value, which may trigger a taxable capital gain if the fair market value is higher than the purchase price (yet a capital loss would not be tax-deductible). For instance, if an individual buys a stock of XYZ in 2021 for $100 and decides to contribute this stock to their RRSP in 2022 when that stock is valued at $120, the individual will need to pay tax on the capital gain of $20 ($120-$100). This contribution will be calculated on the fair market value; thus, this individual will need to have a contribution room of at least $120 in their RRSP to transfer the asset to the account.
There are few situations where one can contribute to their RRSP without affecting their deduction limit. One example is a lump-sum transfer from a registered pension plan or another RRSP. Another such case is some allowances upon retirement, but they can only be executed under some very specific guidelines.
6. Withdrawals
Unlike TFSA withdrawals, which occur without tax implications, withdrawals from an RRSP before retirement will trigger withholding tax. This tax is calculated based on the amount withdrawn. A breakdown of this tax can be found in the following table:
|
|
All Provinces (except Quebec) |
Quebec |
|
Amount withdrawn |
Federal Tax |
Combined Federal and Quebec Amounts |
|
Up to $5,000 |
10% |
20% |
|
$5,001 to $15,000 |
20% |
25% |
|
More than $15,000 |
30% |
30% |
Table 1. Withholding Taxes
Note that more tax may be payable at year-end depending on the income level of the investor.
7. Spousal RRSP
One can also contribute to an RRSP registered under the name of their spouse. The amount that an investor can contribute to this plan depends on their own contribution room, and not on the spouse’s contribution room. For instance, an investor with a $10,000 contribution limit can choose to put it in their own account, in their spouse’s account, or split it among the two. The total contributions to the two accounts cannot exceed the $10,000 limit the investor has no matter what the contribution limit of their spouse is.
If funds are withdrawn from a spousal RRSP, the funds can be taxed either under the contributor or under their spouse, depending on the time of the contribution. If the withdrawal occurs within two calendar years of the deposit of the contributor, then the contributor is taxed on the withdrawn amount. Any funds that have been in the account for three or more years are taxed in the hands of the account holder. For instance, if an individual invests $2,000 per year every year before this year in a spousal RRSP and $10,000 are withdrawn today, $4,000 would be taxable income for the contributor (the $2,000 from the previous year and the $2,000 from the year before that), and the remaining $6,000 would be taxed under the spouse.
8. RRSP Termination
Withdrawals and termination of the account are allowed at any time; however, a mandatory termination is triggered in the year the account holder becomes 71 years old. At this point, they will have a few options on how to redeem their investments. The proceeds from the investments can either be withdrawn in a taxable lump sum, transferred to a Registered Retirement Income Fund, invested in an annuity, or a combination of these options.
A RRIF is another investment vehicle that helps investors defer taxes. Investors are required to withdraw a certain minimum amount each year. If the individual is of age less than 71, then the percentage for the year is calculated as 1/(90 – age). If the individual is of age higher or equal to 71, then they should follow a prescribed percentage by the Canada Revenue Agency.
An annuity is an interest-bearing investment that allows investors to receive pre-determined amounts at equal periods of time, like every month or year, until the investment is paid back in full. Another option is a deferred annuity which is an annuity with a start date deferred to a certain point in the future.
In the event of the death of the account holder, the assets could be transferred to a beneficiary RRSP account without tax implications. If no such transaction occurs, then the proceeds are taxed at the deceased’s marginal tax rate in the year of death.
When the investor receives their proceeds in any of these ways, they will need to pay tax on them. All returns are considered taxable income, meaning that there will be no tax credits for the dividends received, nor any reductions of the taxable amount of the capital gains (dividends from Canadian corporations would usually offer tax credits, and only 50% of the capital gain is considered taxable income).
9. When to Use an RRSP?
One should carefully analyze their options before choosing the right investment vehicle. For instance, an investor anticipating needing funds before retirement should probably invest in a TFSA instead since RRSP withdrawals are taxable. Having said that, RRSPs are perfect for investors who want to save money specifically for retirement. RRSPs always make sense for high-income earners.
Author: Alexander Natchev