RRSP - Understand the Basics & Get Started!
If you're an investor in Canada, you simply can't afford to ignore the Registered Retirement Savings Plan (RRSP). Along with the TFSA, it's hands down the most effective investment account to build a large corpus for the long term. Ostensibly aimed at retirement planning and very effective at that, the RRSP has evolved to provide solutions for various other needs as well, including as a tax-free savings vehicle for a home down payment or for continuing education. There's also a way to reduce payments on a high-interest loan using the RRSP (but that's for a separate article).
The first thing to understand about RRSPs is that they're registered investment accounts; which means that they're officially given tax-deferred or tax-sheltered status. This is beneficial to you since registered accounts are built to provide tax advantages aimed at allowing you to grow your money effectively. On the other hand, nonregistered accounts offer no special tax benefits, and therefore, all interest, dividends, and capital gains earned within these investments are usually taxed as per the regular laws of the tax code. Since there are definite advantages to registered accounts like the RRSP, they come with restrictions and rules that are meant to keep the playing field as far as possible while also balancing larger issues such as fiscal policy.
Contributions
Since the RRSP is an investment account, it all begins with making investments or in other words, 'contributions'. Once you've decided that you want to invest in an RRSP, the first question that arises is how much you can legally invest. Unlike a non-registered account, you cannot contribute unlimited sums of money to your RRSP.
The amount you can legitimately contribute to your RRSP is 18% of your previous year's earned income, up to a maximum limit which is currently $27,230 for 2020.
So, if you earned $80,000 in 2019, your RRSP contribution limit is $14,400 calculated as 18% of 80,000.
Deductibility
There's a limit to the amount you can legally contribute to your RRSP because of its magical ability to reduce your taxable income, thereby reducing your tax owing. Earning higher amounts of income is a desirable outcome, but it also raises your income taxes.
What if you could notionally reduce your earnings in order to reduce tax as to keep more money to yourself? That's what the RRSP does by offering you a deduction equal to the amount of your contribution.
Your entire RRSP contribution amount may be deducted from your taxable income so as to lower your tax liability. For example, if you contributed the entire $14,400 to an investment within an RRSP, your taxable income would drop from $80,000 to $65,600, calculated as $80,000-$14,400. Therefore, your tax liability would be calculated based on a lower amount. In this case, it would result in an estimated tax saving of roughly $4,3181. That's over $4,300 of extra money you didn't expect to have! This extra money could be used for various purposes such as a family vacation, paying down high-interest debt, or making TFSA contributions!
Carry Forward
The plan gets even better because your RRSP contribution room carries forward indefinitely, meaning that you are not obliged to use any or all of your room in any particular year. You may keep your contribution room and use it some time down the road if you anticipate being in a higher tax bracket in the foreseeable future. Let's suppose you wanted to contribute $10,000 to your RRSP for the tax deduction and say $5,000 to your TFSA. In this case, the remaining $4,400 ($14,400-$10,000) would be carried forward to be used at a point in time in the future. However, don't get carried away and contribute over your allowable limit since that will attract penalties. You won't be penalized as long as you're over 19 years of age and you're over-contribution has not exceeded $2,000. However, once you exceed that buffer limit you could attract penalties of 1% per month. Plus, it's the investor's responsibility to keep track of payments and to make sure that they don't overcontribute; neither CRA nor your financial institution will take responsibility to warn you of your approaching limit.
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Qualified Investments
A tax deduction is helpful as long as the instrument you're investing in has a return expectation aligned with your investment goals. This is where the RRSP (and the TFSA for that matter) really shines. The list of investments you are permitted to hold in these accounts is extensive, ranging from plain vanilla Guaranteed Investment Certificates (GICs) to stocks, bonds, mutual funds, segregated funds, ETFs, gold, and a lot more! However, real estate is not a qualified investment, although REITs and other real estate funds may be. Canadian investors have access to these instruments irrespective of the manner in which they go about their investments. Whether you prefer a DIY approach or working with an advisor like myself, the options are numerous and there's something out there for all types of investors. A 30-year-old investor may want to construct a growth-based portfolio of stocks and ETFs, while somebody preparing for retirement may prefer a balanced or conservative portfolio comprising segregated funds or mutual funds.
Tax Deferral and Taxes on Withdrawal
Once you've determined your contribution limit, decided on how much to contribute, and chosen your investments based on your goals and risk profile, your investments continue to grow tax-deferred until withdrawn from the account.
In addition to reducing your taxable income, your investments within an RRSP are also tax-deferred while within the account. This means that interest, dividends, and capital gains received while the money remains invested in an RRSP are not taxed, thereby allowing the investments to compound without losing money to taxes each year.
Tax distributions received through investment funds are not taxed in the year they are received as long as the money remains invested in the RRSP. This is not true in the case of non-registered accounts since you may have to pay taxes on distributions even if you continue to remain invested.
While RRSP contributions are tax-deductible and tax-deferred, they are taxed on withdrawal.
In other words, when money is withdrawn from your RRSP account, you are required to add it to your income and pay the appropriate taxes on it. Withdrawing funds from an RRSP can be complicated for somebody unfamiliar with the system so don't do so before getting trusted advice and doing thorough research. To understand this process better, you'd need to know what a Registered Retirement Income Fund (RRIF) is and that'll be covered in a subsequent article.
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Footnotes