An RRSP, or Registered Retirement Savings Plan, is a type of investment account designed to help Canadians save for their retirement. There are many benefits to an RRSP, including tax savings and the potential for investment growth. However, there are also some downsides to consider as well.
The choice of how you want to save your money for retirement will be up to you. But make sure you’re well informed and know where your money is being invested.
What is an RRSP?
To put it simply, an RRSP is an account where you can contribute money pre-tax and let that money grow tax-free until you withdraw it. You have a maximum amount you can contribute to your RRSP each year, and its contents determine its growth.
When you withdraw money from your RRSP, it’s considered ordinary income and will be taxed according to your marginal tax rate.
Pros of an RRSP
Contributions to an RRSP are tax-deductible, meaning that you can deduct the amount you contribute from your taxable income. This can result in a lower tax bill, which can be significant depending on your income level and how much you contribute.
For many people, the fact that RRSPs are tax-deferred is one of the main reasons to go with this saving option. This means that returns for RRSP investments are exempt from any capital gains tax, dividend tax, or income tax. This effectively delays the payment of taxes until retirement, when your marginal tax rate might be lower than it is during your working years.
It’s Possible to Make Certain Withdraws Tax-Free
A major benefit of RRSPs is that you can technically withdraw your money whenever you want. This could work well for people who end up retiring early or want some flexibility with their investments.
This money will still be taxed as ordinary income unless it’s used to get an education or buy/build a home through the Lifelong Learning Plan or the Home Buyer’s Plan.
Generally, RRSPs are protected from seizure if you have to declare bankruptcy. This means you won’t lose all your savings if you end up in this unfortunate position.
Cons of an RRSP
One downside to an RRSP is that there are limits on how much you can contribute each year. Your annual income defines your max contribution, which may be a disadvantage for lower-income earners as they’ll have a much lower cap for their contribution.
For example, in the 2022 tax year, the contribution limit is 18% of the earned income you reported on your 2021 tax return, up to a maximum of $29,210. You’ll be subject to a penalty tax if you go over this limit.
While you can withdraw from your RRSP at any age, doing it before you turn 71 will result in you paying a heavy withholding rate. For most Canadian provinces, you can expect to pay:
10% on amounts below $5,000
20% on amounts between $5,000–15,000
30% on amounts over $15,000
Quebec has slightly different federal rates. However, they charge an additional provincial tax. The federal rates for Quebec are:
5% on amounts below $5,000
10% on amounts between $5,000–15,000
15% on amounts over $15,000
This withholding tax is in addition to the income tax you’ll also be paying on the withdrawal. While this may seem punishing, it incentivizes you to keep your money in the plan.
Mandatory Withdrawals at 71
An RRSP has a set date when they mature. In the year that you turn 71, you’ll have to either withdraw the balance and face the income tax it brings with it or shift it into a Registered Retirement Income Fund (RRIF).
This mandatory withdrawal means you can no longer take advantage of your plan's tax deferment and investment benefits. It also means that if you want to retire before you turn 71, you’ll have to continue investing in your RRSP or face the withholding rate penalties we mentioned previously.
Planning for Your Retirement
In conclusion, an RRSP can be a valuable tool for saving for retirement, but weighing the pros and cons before opening an account is essential. The tax savings and potential for investment growth can be significant, but the contribution limits, withdrawal penalties, and expiration date may not make it the best choice for everyone.