“Don’t miss the deadline!”
“Contribute today!”
“Save on tax!”
These are common phrases we see all around us as the RRSP (registered retirement savings plan) deadline approaches. The financial industry has led Canadians to this view of if you don’t want to pay taxes, contribute to RRSPs. This puts us on autopilot as we make these contributions.
However, do you fully understand how a RRSP works?
A RRSP is an account, registered with the federal government, that you use to save for retirement. RRSPs were introduced in 1957 as an essential retirement tool as, at that time, the only retirement program available was the Old Age Security. There are special tax advantages within RRSPs which allow for you to defer the tax until retirement.
Ok, good to know the background, but how does this work?
Contributions to RRSPs reduce your taxable income (thereby reducing the tax you pay). The contribution you make, as well as all earnings on your investments within your RRSP, gets to stay tax free until you withdraw the funds. Contributions are limited to a maximum of 18% of your prior years earned income, up to current years RRSP dollar limit (in 2018 this is $26,230). You can contribute up to your available limit, which includes carry forward amount from prior periods. Your contribution room is listed on your notice of assessment, or CRA my account.
The Income Tax Act also allows for an individual to contribute to a spousal RRSP and claim the deduction yourself (so you would get the tax deduction, and your spouse will claim the income upon withdrawal). This is a great income splitting tool if your spouse’s projected income on retirement will be lower than yours. Note that the amount you contribute to your spousal RRSP is based on your limit less what you contributed to your own RRSP.
Let’s illustrate how taxes work with an example.
Sam earned $70,000 in 2018. He can therefore contribute a maximum of $12,600 to his RRSP (18% of $70,000). Assuming Sam has $12,600 available this year to contribute, Sam will get a tax deduction thereby bringing his taxable income down to $57,400. Sam will therefore only pay income tax based on the $57,400 amount, and not the $70,000. If Sam is an employee who was withheld income tax at source through payroll deductions, this could result in a tax refund for Sam (of up to $3,700 in Ontario!). In addition to getting the tax deduction, all the growth in the RRSPs (i.e. capital gains, dividends, interest) will grow tax free until Sam decides to pull funds out of his RRSP.
Tax deferral and tax-free growth! This sounds amazing, right?
While you get the current tax benefit from contributing to your RRSP, you need to understand that RRSPs are fully taxable. They offer tax deferral, NOT necessarily tax savings. When you withdraw the funds from your RRSP, you will be taxed on 100% of the withdrawal. There is the potential for paying more in tax than you saved (depending on when you take deduction). In the ideal situation, you are making less when you withdraw the funds then when you made the contribution (and took the deduction for taxes). This will allow for tax savings.
On the topic of tax-free growth, it is important to note that the nature of investments is lost and you pay tax on 100% of income (so if you incurred a capital gain or earned a dividend, you lose out on the tax perks of those types of income). Therefore, there are some considerations to make before coming up with the conclusion that RRSPs are a tax savings vehicle for you. To learn more, read To RRSP or not RRSP.
To continue on the topic of understanding RRSPs, it is important to note that RRSPs are not solely for retirement planning. Contributions made to an RRSP can be used towards education or purchasing your home.
With the home buyers plan (HBP), if you’re in the market to buy or build your first home, you can borrow up to $25,000 tax free from your RRSP. However, you need to repay this annually over the next 15 years (1/15 per year).
The lifelong learning plan (LLP) allows you to borrow funds from your RRSP to help finance education for you or your spouse/common-law partner. The maximum withdrawal is $20,000 per taxpayer for a total of $40,000 for a couple. You must repay the withdrawn amount to your RRSP in minimum annual payments over a maximum repayment period of 10 years.
While these special programs are nice, you need to make sure you can afford the repayment. For both the HBP and LLP, if you don’t repay the minimum in a particular year, the amount not repaid would be taxable income in the year.
I bet you will think more about that RRSP contribution you make!
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