A Registered Retirement Savings Plan is one of the principal investment vehicles Canadians use to set money aside for retirement. In addition to retirement, you can also use funds in an RRSP account to pay for a home, go back to school, and minimize your income tax burden.
Here are some more details on the things you can do with your RRSP funds.
1. Buy A Home Using The Home Buyers’ Plan
The Home Buyers’ Plan (HBP) is a program that allows you to withdraw up to $35,000 (or $70,000 for a couple) and put it towards the purchase of your first home. This amount can be withdrawn tax-free and re-contributed later. Eligible funds must have been in your RRSP for at least 90 days.
Complete Form T1036 and give it to your bank. Funds can be taken out once or multiple times, however, all HBP withdrawals must be completed within the same year.
After buying your home, you have 2 years from the date you made the withdrawal to start paying back your HBP. The total amount must be paid back within 15 years. Every year, the Canada Revenue Agency will send you a Notice of Assessment that shows how much you have repaid and what’s left.
Advantages of the Home Buyers’ Plan
It allows first-time homebuyers to access additional funds they can put towards a down payment or that they can use to cover closing costs. Unlike other RRSP withdrawals, an HBP withdrawal is tax-free and can be re-contributed.
Couples who are buying a home together get double the maximum withdrawal amount of $70,000.
Disadvantages of the Home Buyers’ Plan
The RRSP is designed to hold your retirement savings. When you withdraw funds you could lose out on growing your retirement pot if you do not repay the loan back in time.
- How To Buy A Home in Canada – A Complete Guide
- How To Pay Off Your Mortgage 10 Years Early and Save $72,000
2. Go Back To School Using The Lifelong Learning Plan
If you or your spouse decide to go back to school full-time, RRSP funds can be used to pay for your education through the Lifelong Learning Plan (LLP). Using Form RC96, you can withdraw up to $10,000 per year and up to $20,000 in total.
Funds are withdrawn tax-free under the LLP and must be re-contributed within 10 years. Unlike an RESP, you cannot use the LLP to pay for your children’s post-secondary education.
Read more details about the Lifelong Learning Plan here.
3. Contribute To A Spousal RRSP
If you earn more money than your spouse, you can lower your combined taxes in the future and increase your tax refunds (deductions) now by contributing to a spousal RRSP.
For example, let’s look at a couple, Mr. Ashern and Mrs. Ashern.
Mr. Ashern earns $100,000 (and a marginal tax rate of 40%) while Mrs. Ashern who works part-time earns $50,000 per year (and a marginal tax rate of 30%). Every year, Mr. Ashern can contribute up to $18,000 to his RRSP and Mrs. Ashern can contribute $9,000 to hers.
Mr. Ashern can contribute a portion of his annual RRSP contribution limit to a spousal RRSP in order to lower his overall income in retirement. He will receive a tax deduction (tax refund) at his higher marginal tax rate, while Mrs. Ashern will pay taxes at a lower rate when she withdraws funds in retirement. They end up with the same total income but pay less tax overall.
RRSP accounts are required to shut down when the owner turns 71. If you still have contribution room at age 71, you can continue to contribute to a spousal RRSP if your spouse is younger and save on taxes.
Further income-splitting using RRSPs can be accomplished by converting all or part of the RRSP funds into an RRIF or Annuity at age 65+. Up to 50% of RRIF or annuity income can be split between couples i.e. transferred to a lower-earning spouse to save on taxes.
RRSP Over-Contributions and the Over-Contribution Penalty
Every year, the Feds announce the new RRSP limit. You can contribute this limit during the calendar year and during the first 60 days of the following year. For example, the RRSP limit for the 2020 tax year is 18% of your 2019 income up to a maximum of $27,230.
You are able to contribute funds throughout 2020 as well as during the first 60 days of 2021 up until March 1, 2021 (aka RRSP Season). Contributions made during the first 2 months of the year can be used to claim tax deductions for either the previous or current tax year.
Be careful about over-contributing. When you contribute more money to your RRSP account than you are allowed during any particular year, it can result in a 1% monthly penalty tax on the excess amount. A $2,000 buffer is allowed before the 1% tax kicks-in which is why some people deliberately over-contribute to max out their RRSP account.
If you mistakenly over-contribute to your RRSP, quickly withdraw the excess amount to avoid an additional 5% tax. CRA may waive the tax in some cases where you can show that the excess amount was due to a reasonable error and that the excess contributions have been withdrawn.
Closing Your RRSP Account
You are allowed to voluntarily close your RRSP account at any time. When you withdraw funds from the account, it is immediately subject to a withholding tax that your bank pays to the government. The withholding tax rate is between 10% to 30%, except for Quebec where it is 21% to 31%. These rates include provincial withholding taxes as well.
For example, if you take out $10,000 from your RRSP, the bank deducts $2,000 (20% tax rate), leaving you with $8,000.
The money you withdraw is also considered taxable income and is reported on your tax return. Depending on your total income and tax bracket for the year, you may owe additional taxes or may be eligible for a tax refund at tax time.
At age 71, the government requires that you shut down your RRSP account and do one or a combination of the following:
- Withdraw the cash (withholding taxes are applied)
- Transfer the funds into a Registered Retirement Income Fund
- Purchase an Annuity
How To Invest Your RRSP
You can hold a host of investments in your RRSP account including stocks, bonds, mutual funds, ETFs, index funds, high-interest savings, mortgage-backed securities, GICs, and several others. The allowed investments are referred to as ‘qualified’ investments.
Some assets are deemed as non-qualified or prohibited investments and attract a tax-penalty that is 50% of the fair market value of the non-qualified or prohibited investment plus a 100% advantage tax on any income earned on the assets.
RRSP vs. TFSA
Ideally, you want to contribute to both accounts, but if you had to make a choice between investing in your TFSA or RRSP, what factors should you consider?
1. Tax bracket now and in retirement: If your tax bracket in retirement is going to be lower than your current tax rate, an RRSP often makes the most sense. When the reverse is the case, a TFSA gives you the best bang for your bucks and you should max it out first.
2. When you are just starting out in the workforce on an entry-level salary, you are better off contributing to a TFSA and accumulating RRSP contribution room until when your income tax rate and tax deductions increase. Note that this rationale becomes invalid if your employer provides any form of RRSP contribution match through a Group RRSP. Do not leave free money on the table!
3. If your income in retirement is going to be small and you expect to qualify for Guaranteed Income Supplement, RRSP income can put you over the income threshold, so it is best to maximize your TFSA first.
How Much Money Will You Need in Retirement?
What income or savings do you need to have to retire comfortably in Canada? The jury is still out on the magic number, however, here are some popular rules of thumb:
A. 4% Withdrawal Rate – Rule #1
If you can figure out your expected expenses per annum, you can use a 4% withdrawal rate to compute the lump-sum amount you need to have on your retirement day. For example, if you feel $40,000 will meet your annual needs, you require $40,000/4% or $1 million dollars!
B. Desired Income x 25 – Rule #2
Similar to rule #1, if you feel $40,000 is adequate, multiply that by 25 and you will need to have $1 million bucks invested by your retirement date.
C. 70% of Your Pre-Retirement Income – Rule #3
Assuming your mortgage is paid off and your kids are out of the home, this rule states that you should require about 70% of your current annual income in retirement. For example, if you earn $57,000 or so per year, 70% of this income is $40,000.
Using multiples of 25 (from rule #2), this infers that you will need: $40,000 x 25 = $1 million.
Note that these calculations do not include expected government pensions and benefits e.g. Old Age Security, Canada Pension Plan, etc. If for example, you expect to receive approx. $20,000 in combined OAS and CPP annually (based on the maximum amounts paid in 2018), you will only need to find the remaining $20,000 (assuming your annual retirement cash need is $40,000).
Going back to rule #2, you will now need to have $500,000 saved for retirement i.e. $20,000 x 25 = $500,000.
All these are rough estimates and everyone’s situation is different. However, this is a good starting point for estimating your income needs in retirement.
- How To Generate Retirement Income From Your RRSP
- A Financial Checklist For Canadians
- Overview of Federal Retirement Benefits Available To Seniors
- Overview of Provincial Retirement Benefits For Seniors
- How To Use A LIRA To Generate Retirement Income