Many people feel pretty confused about RRSPs - how they work, and why they're useful. At the same time, people can feel embarrassed to ask for a full explanation.
To help you move forward with this useful tool, here is your RRSP Primer!
What is an RRSP?
"R.R.S.P" is an acronym for "Registered Retirement Savings Plan".
It's not a type of investment, like a stock or a GIC. It's a type of account, inside which you can purchase investments.
It differs from other accounts in the tax treatment it receives.
RRSP Contributions
Each year, when you contribute to your RRSP, that amount is is deductible from your income for that tax year. Because people often don't know what they've made for the year until the year is done, and because December is a lousy time for most people to think about savings, you can make contributions for last year up until the first 60 days of this year.
There are limits on the amount you can contribute to your RRSP each year. This limit is based upon your prior year's earnings, and can be found on your most recent Notice of Assessment from the Canada Revenue Agency. Or, if you've lost that, you can call them.
Your allowable contribution for the year is the lower of:
- 18% of your earned income for the previous year
- The maximum annual contribution limit for the taxation year ($24,930 in 2015 and $25,370 in 2016)
- The remaining limit after any company sponsored pension contributions
If you don't use your contribution room in a particular year, then it carries forward to next year.
EXAMPLE:
Krysten earned $10,800 in RRSP contribution room in 2013, and only contributed $5,000.
She earned another $11,700 in RRSP contribution room in 2014.
Krysten's 2015 RRSP contribution room is therefore:
- $10,800 MINUS $5,000 = $5,800
PLUS
- $11,700
EQUALS
- $17,500
She has $10,000 to contribute this year. The $7,500 balance will carry forward to next year.
Company Pension Plan or Deferred Profit Sharing Plan
If you are lucky enough to have one of these, you need to pay attention to the contribution amount - or "pension adjustment" - as this will reduce your RRSP contribution room. Yet another reason why you have the first 60 days of the year to contribute: you may not know this amount yet.
You can find your Pension Adjustment (PA) amount on your T4.
Tax Deductions
When you make a contribution to your RRSP, the Government of Canada congratulates you on your prudent savings by giving you a tax deduction. What does this mean?
EXAMPLE:
Shannon's 2015 taxable income is $75,000. She lives in British Columbia, so her tax payable in 2015 will be $15,944.
Her contribution room is $28,000. If she contributes the entire amount, her taxable income for the year will therefore be ($75,000 - $28,000) = $48,000.
Shannon's tax payable would end up being $7,925. If her employer has been submitting her taxes on her behalf throughout the year, she could* receive a refund of $8,019 ($15,944 - $7,925).
Tax Sheltering
But wait... there's more! Now that Shannon and Krysten have made their contributions to their RRSPs, they intelligently invest those funds. They can invest in mutual funds, exchange-traded funds (ETFs), segregated funds, cash deposits, guaranteed investment certificates, government bonds, and publicly traded stocks and bonds.
Since they're so bright, they make a decent return on their investments. As an example, let's say that Shannon earns 5% on her $28,000 investment - after fees. That's $1,400.
If those funds were outside of an RRSP or TFSA (look for more on TFSAs in another article!), she'd have to pay tax on that $1,400. Whether it was made up of interest, dividends, or capital gains would change how much it was taxed, but to make it simple let's just assume it's all interest and 100% taxable.
Shannon would add that $1,400 investment income on to her $75,000 earned income when she filed her taxes for the year, and she'd likely pay around $434 in taxes.
Instead, because she earned that $1,400 inside an RRSP, she gets to keep her $434 and continue to grow it. Obviously, she's going to make a lot more money on $1,400 than she would on $966 - the amount she would have left over if she had to pay taxes - so she benefits from compound growth as long as she leaves the money in her RRSP.
In the long run, the RRSP will allow Shannon to keep more of her earnings and grow them further to benefit her future retirement.
A Word on Withdrawals
During your saving years, you are benefiting from a tax deduction and tax-sheltered growth.
During your withdrawal years, when you are assumed to be retired, you're earning less. Each withdrawal you make from your RRSP is 100% taxable as income.
The assumption is that your income tax bracket is lower in your retirement years than it is in your working years. Whether or not this is the case will be dependent upon your own situation in retirement - your sources of income, your age, your spending habits, and your family composition.
For more information on how you can use your RRSPs to your advantage, please contact us.