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(Enriched Academy Financial Coach / CFP)
It’s RRSP (Registered Retirement Savings Plan) season again as the March 1 contribution deadline is looming. All over your news feed you can see articles popping up about what is an RRSP? how does an RRSP work? and how much to contribute to your RRSP? There is a ton of information floating around and we have outlined a few of the basics below, but you may also want to seek professional financial advice on how to take advantage of the specifics of your situation. Either way, we'd like to provide you with some important factors to consider when deciding if, and how much to contribute to your RRSP this year.
RRSPs are a type of registered account that allow you to invest the funds you deposit into the account. Your contributions are tax deductible and investment earnings in the account can grow tax-sheltered until withdrawal, at which point they are taxed as income. The idea is that you can grow your money through investing and then withdraw the funds during retirement when your income tax rate is lower, thus putting more money into your pocket.
RRSP contributions are limited by a yearly maximum amount depending on your income, although you can carry forward unused amounts to reduce taxable income in future years. There are also limitations and possible penalties on withdrawals and overcontributions to an RRSP. Withdrawals from an RRSP prior to age 71 are subject to income tax and an additional withholding tax. A further caveat is that when you withdraw money from an RRSP, the contribution room you used to deposit that money is gone forever. One exception is the Home Buyers’ Plan, which allows you to borrow up to $35,000 tax-free from your RRSP to buy a house with no penalty — although it is a loan and must be paid back within 15 years to avoid taxes.
Unlike a Tax-Free Savings Account (TFSA) which has a minimum age of 18, there is no minimum age limit to open an RRSP, as long as you have earned income. RRSP accounts must be closed and the funds withdrawn or converted to a Registered Retirement Income Fund (RRIF) at age 71. A RRIF provides a steady stream of income since you must withdraw some of the funds on a regular basis, but you still receive tax-sheltered growth of the remaining funds. The minimum amount that must be withdrawn each year is determined by the holder's age and the value of their RRIF account, and the withdrawals are taxed as income in the year they are received.
Plan for retirement by contributing during peak earning years
Peak earnings are the years in which you earn the largest amount of income. Keep in mind that your income doesn’t just come from your employer’s paycheque or your earnings as a contractor. It’s also made up of things like rental income, some government benefits, and growth on any non-registered investments you may hold. These are the years where you can likely take the largest advantage of all the benefits of an RRSP. Typically, individuals earn less in retirement than in their peak earning years. This allows you to not only benefit from deferring tax, but also from withdrawing retirement savings in a lower tax bracket.
How do I know my income is peaking?
No one knows exactly what the future holds. You may get promoted, get a big raise, change careers, go down to part-time work, retire early, purchase an investment property, or a combination of the above. This means, like most things financial planning related, we need to make a best guess based on what we know today. Base your assumptions on what you have planned and what you hope and/or are working towards in the future.
If you are just starting out in the work force, or in a new career it’s likely that these aren’t your peak earning years. If you have a significant amount of experience in your industry, are in the position you expect to remain in until retirement or are focused more on work/life balance than doing anything it takes for that next promotion, you may be at or near your peak earning years.
What happens if I contribute to my RRSP in lower earning years?
You will still receive your RRSP contribution tax deduction and defer taxes on both the contribution and growth. However, you could be deferring tax now only to pay a higher tax rate on withdrawals from your retirement fund in the future. You’ll also be using up contribution room that would be more beneficial to use in your peak income earning years due to being in a higher tax bracket at that time.
My income is low – What retirement savings account is best for me?
A Tax-Free Savings Account (TFSA) is another retirement fund option. It differs from an RRSP account by offering tax-free growth, meaning you won’t pay taxes when you pull money out of this account at any time. Money withdrawn from a TFSA doesn’t count as income.
The money you contribute to this account has already been taxed and the value of the tax benefits is derived from the growth — making it really important to invest the money according to your risk tolerance and maximize the tax benefits from this account. If you’ve already utilized all your TFSA contribution room and still have additional retirement savings, you may want to consider contributing to your RRSP account and deferring the RRSP tax deduction.
Why would I defer an RRSP deduction?
At tax time you can select what to do with the RRSP contributions you’ve made that year – take the deduction in the current tax year or defer the deduction to a future tax year by completing schedule 7. By making the contribution now, you are still benefiting from the tax deferral on both the contribution and growth, but by deferring the deduction you can now wait and use it in year peak income earning years when you are in a higher tax bracket.
How much can I contribute to my RRSP?
Your contribution room (deduction limit) for this year can be found by logging in to your CRA “My Account” and scrolling to the bottom of the page. Your RRSP contribution room is also indicated on your previous year’s notice of assessment. Each year’s unused contribution room is carried forward indefinitely. It increases by an additional 18% of your prior year's earnings up to an annual maximum ($29,210 for 2022). Your notice of assessment provides a detailed breakdown of the calculations used in your specific situation to arrive at your contribution room each year.
How to open a RRSP account?
You can open an RRSP account with a financial services institution or through a self-directed investing platform – they'll provide the option to make a lump sum deposit and/or regular contributions. If you already have an RRSP you can make additional contributions to that account. If you’re not satisfied with your current institution/planner, you can open an RRSP account with a different institution. Keep in mind that the more accounts you have open the harder it is to track/manage.
If you’re opening a new account, it’s typically easiest to transfer any other accounts you have to the new RRSP. You just need to submit a transfer form and they can take care of the transfer for you. Transferring will not impact your contribution room, but it's very important to use the transfer form and not withdraw from your RRSP and then contribute (this will have tax consequences). You’ll also want to consider your RRSP investment options and ensure the institution you select offers those options.
What are my RRSP investment options?
An RRSP can hold “qualified” investments. Common types of qualified investments include: cash, individual stocks (if they trade on a major domestic or foreign stock exchange), government bonds, corporate bonds, savings bonds, mutual funds, index funds, exchange-traded funds (ETFs), segregated funds, mortgages & mortgage-backed securities, shares in Canadian small businesses, gold & silver.
If you’re currently holding cash in your RRSP you are losing out on the biggest advantage — tax deferred growth. You’re also losing to annual inflation! This can have a devastating impact on your retirement savings over the long term. It’s also important to note that just because an investment qualifies under the RRSP rules doesn’t mean it’s the right investment for your situation. It’s important to assess your risk tolerance and invest accordingly in a well-diversified portfolio that aligns with your goals.
Pay back debt or add to retirement savings?
This depends on the type of debt and your interest rate. It typically makes sense to pay down debt before investing because of the high cost of carrying that debt. It’s hard to get ahead by saving when your return on your investments is less than the interest you are paying. For example, if you invest according to your risk tolerance and your average rate of return ranges from 3% to 7%, it doesn’t make sense to pay 19% interest on a credit card balance or 8% on a line of credit. You would get much further ahead by paying down the debt and ensuring you have a plan, so you don’t just rack it back up again!
Emotion and human behaviour can play a large role in financial decisions. It's important to research the facts, seek professional advice if your situation warrants it (preferably from someone who doesn’t benefit from selling investments), and carefully consider all the factors of your situation to make a decision that works best for you.