The RRSP which in full reads as “Registered Retirement Savings Plan” is a sheltered account provided by the government to Canadians to help them save for retirement. The RRSP has been around for a while (since 1957) and has been regarded as a mainstay of the third pillar of retirement income in Canada, in addition to workplace pensions.
When you contribute to your RRSP account, you get a tax break (i.e. contributions are tax-deductible), and any returns generated in your account stay tax-free and continue to grow until you start making withdrawals down the road.
When it comes to growing your retirement pot, time is your best friend. Starting early means that the combination of tax-sheltered earnings, tax-savings on your contributions, and compound interest can combine to make your retirement income goals a reality.
Below, I discuss all the basic information you need to know about the RRSP:
Types of RRSP Accounts
RRSP accounts can be categorized based on several factors, including who makes the contributions, who decides on what investments are held, and how funds in the account are pooled together. In general, you will come across the following RRSP accounts:
- Individual RRSP: Here, the account is open in your name, you make all the contributions and claim any tax benefits generated by your contributions.
- Group RRSP: Your employer may offer a group RRSP plan that allows employees to save for retirement, while the employer may also contribute. Employee contributions are made automatically through payroll deductions.
- Spousal RRSP: One spouse can contribute to the RRSP account of the other spouse as a means of splitting retirement income and lowering the couple’s overall tax burden in retirement. Usually, the way this works is that the higher-earning spouse contributes to an RRSP account registered in the name of the lower-earning spouse. The contributor claims tax-deduction on the amount they contributed. When funds are withdrawn in retirement, the spouse who owns the account pays taxes based on their own tax rate.
- Pooled RRSP: This is technically referred to as a “Pooled Registered Pension Plan (PRPP).” It allows self-employed individuals and employees of small businesses who have no access to a group RRSP or workplace pension to participate in a plan that pools contributions from employees and their employers. This plan makes fund administration cheaper than if a single employer or business were to set it up.
How Much Can You Contribute to an RRSP?
Every year, the government allows you to contribute up to 18% of your “earned” income for the previous tax year. For example, for 2019, you can contribute 18% of the income you earned in 2018, up to a maximum amount of $26,500. By “earned” income, it means you need to earn income to create RRSP contribution room. This income can be from a variety of sources, including employment, rent, royalties, alimony, research grants, business income, etc.
You do not have to use up all your contribution room for the year. Unused contribution room can be carried forward indefinitely and this will increase how much you can contribute in future years. You can confirm what your current total RRSP contribution room is by checking the Notice of Assessment (NOA) you received from the Canada Revenue Agency (CRA) for last year’s tax return.
Contributions made to a workplace pension plan will lower your RRSP contribution limit (aka Pension Adjustment). You can contribute to an RRSP until the end of the year when you turn 71 years of age.
Further reading: RRSP Contribution Limits for 2019
Penalties For Over-Contributing to an RRSP
Contributing to your RRSP account will help you save for retirement. However, if you contribute more than you are allowed to, the government will slap you with a penalty tax. This tax is 1% per month on cumulative excess contributions exceeding $2,000. Everyone gets a lifetime wiggle room of $2,000 in excess RRSP contributions before penalties kick in.
For example, if you have an over-contribution of $5,000 in your RRSP account, a monthly penalty tax of 1% per month is levied on $3,000 (that is $5,000 minus the $ 2,000-lifetime exception) every month until the excess amount is withdrawn. Using this example, this amounts to :
- $3,000 x 1% = $30 per month or $360 per year in over-contribution penalty.
Further reading: RRSP Over-Contribution Penalties
Making RRSP Withdrawals
You are allowed to withdraw funds from your RRSP at any point in time, however, taxes become due immediately after withdrawal. Depending on how much you withdraw, the bank will withhold taxes and pay it to the government on your behalf. Funds withdrawn are also included in your taxable income for the year and depending on your tax bracket, more taxes may be due at tax time.
Withholding taxes held by banks when you make a withdrawal from your RRSP accounts are as follows:
In addition to taxes, when you withdraw from your RRSP before retirement, you lose that portion of your contribution room permanently, except in a few cases. This is unlike for the TFSA account where you can always re-contribute withdrawals in the following year.
RRSP Withdrawals That Are Not Taxed
The government has provided some options for Canadians to make withdrawals from their RRSP without incurring taxes and losing their contribution room. They include:
- Home Buyers’ Plan (HBP): This plan allows first-time home buyers to withdraw up to $35,000 from their RRSP in order to purchase a home. A couple can withdraw up to $70,000 ($35K each). You have up to 15 years to repay the amount back to your RRSP.
- Lifelong Learning Plan (LLP): This plan allows you to withdraw up to $20,000 from your RRSP to pay for further education for you or your spouse. You are required to pay back the amount withdrawn in 10 years.
Further reading: Home Buyers’ and Lifelong Learning Plan – What You Need to Know
Tax Benefits of an RRSP Account
The tax benefits from contributing to an RRSP account are three-fold.
- Tax-Deductible Contributions: Your contributions to an RRSP are pre-tax income. Any taxes incurred on your RRSP contribution is paid back to you at your marginal tax rate. For example, if your marginal tax rate is 43% and you contribute $20,000 in after-tax employment income to your RRSP in 2018, you can expect a tax-relief or refund of: $20,000 x 43% = $8,600. You can also choose to have your taxes reduced at source, so you don’t have to wait till tax-time to get the tax benefits. RRSP contributions essentially lower your income tax.
- Tax-Free Growth: Earnings on your RRSP account remain sheltered from taxes until you start withdrawing funds. This means that dividends, interest income, and capital gains earned on your investments all remain tax-free and continue to compound over time until retirement.
- Lower Tax in Retirement: You will eventually pay taxes on your RRSP account, but if you are like the average Canadian, it will be at a lower tax rate in retirement. Couples can also use a spousal RRSP to split their income in retirement in a way that lowers the overall tax burden of the family.
Opening an RRSP Account
It is super-duper easy to open an RRSP account. You can choose to go with a Direct Plan where your bank or credit union puts your money in investment assets that match your risk tolerance and investment objectives, such as mutual funds, GICs, stocks, bonds, etc. You can also choose to go with a self-directed RRSP account where you are in control of investment purchases and the asset allocation in your portfolio.
Other more recent alternatives include using Robo-Advisors who invest your funds at a much lower fee than is available through active wealth management, while also saving you the stress and rigours of having to manage your investments by yourself.
Further reading: Wealthsimple Review: Low-Fee Wealth Management in Canada
Investment You Can Hold In Your RRSP
You can hold a variety of investments in your RRSP. These are referred to as “qualified investment” and include:
- Mutual funds
- Exchange-Traded Funds (ETFs)
- Stocks (Equities)
- Certain shares of small business and venture capital corporations
- Options, REITs, cash, investment-grade gold and silver bullion, coins and bars.
Investments You Can’t Hold in Your RRSP
There are investment assets that are not permissible for RRSP accounts. They may fall in the “prohibited” or “non-qualified” investments category. To avoid getting dinged, ensure that your asset holdings are obtained through “arms-length transactions” i.e. you should not be too closely connected to the investment in any way. An example of an arms-length transaction means that for instance, you do not directly own 10% or more of the shares of a corporation you are investing in.
Penalties levied on prohibited or non-qualified investments include:
- 50% tax on the fair market value of the investment
- 100% taxes on income earned by the investment
You may be able to request a waiver/refund of all or part of these taxes if you are able to show that you made a reasonable error and dispose of the investment quickly.
What Happens To Your RRSP When You Retire?
At retirement, you can do one (or a combination) of three things with your RSP funds:
1. Withdraw Cash as Lump-Sum: CRA will levy taxes on the cash based on your marginal tax rate.
2. Convert Your RRSP to an RRIF: You can move your funds into a Registered Retirement Income Fund (RRIF). Here your funds continue to stay invested on a tax-deferred basis. You are required to withdraw a minimum amount of income every year which is reported on your income tax return. Tax is paid on withdrawals.
Further reading: Understanding How the RRIF Works
3. Purchase an Annuity: You can purchase an annuity that pays you income in retirement. This can be term-certain or a life annuity.
Further reading: The Place of Annuities in Your Retirement Planning
What Happens To Your RRSP When You Die?
Generally, following death, your RRSP account is deemed to have been cashed out and the proceeds are added to your estate and taxed on your last income tax return. Depending on whether you have designated a beneficiary and who they are, a couple of scenarios may play out:
1. Qualified Beneficiary: If you designated your spouse as the beneficiary to your account, they may be able to transfer the funds to their own RRSP or RRIF and keep the tax-deferred status. Taxes will not be due until they start withdrawing funds. There are several options for financially dependent children who have been designated as beneficiaries to an RRSP account, including purchasing an annuity (before age 18), rolling over the RRSP into a Registered Disability Savings Plan (RDSP), or cashing out.
2. Non-Qualified Beneficiary: These include a financially-dependent adult child (grandchild), charity, or your estate. For all transfers to non-qualified beneficiaries, the full value of your RRSP is reported in your final income tax return and taxed accordingly.
Further reading: What Happens to an RRSP, RRIF, or TFSA After Death?
How To Transfer Your RRSP Between Financial Institutions
You are allowed to transfer your RRSP from one bank to another without tax consequences. The transfer can be conducted “in kind” or “in cash.” Form T2033 is used to process direct RRSP transfers. A transfer fee may be applied.
In addition to transferring your RRSP from one bank to another, you can also conduct transfers between RRSPs and other registered accounts. For example, transfer an RRSP to an RRIF or RDSP account, and transfer an RESP, RPP, or Retiring Allowance to an RRSP.
Further reading: All the RRSP Transfers You Can Do