For the 2019 tax year, the deadline for contributing to your RRSP is March 2, 2020. As this deadline gets closer, you might still be on the edge about whether or not you should contribute to your RRSP. Get all the RRSP information you need here.
In short, you should contribute to your RRSP if:
- You plan on becoming a 1st time home buyer in Canada
- Your income will decrease (due to retirement, changing jobs, etc.) in the near future and move you into a lower marginal tax bracket
- You don’t have other retirement savings and need to get started on your retirement savings
What is an RRSP?
You’ve heard your coworkers discuss their RRSPs, and all you did was nod in agreement - despite not understanding its complexities! The fact that you’ve heard it mentioned all the time doesn’t mean you understand what an RRSP is or what it does. So let’s start from the beginning, shall we?
A Registered Retirement Savings Plan (RRSP) is a savings account or plan registered with the Canadian Federal Government which helps you save for retirement while sheltering you from potential taxes. In this savings-investment portfolio, you can have a healthy mix of different financial products such as savings deposits, mutual funds, bonds, treasury bills, guaranteed investment certificates (GICs), mortgage loans, income trust and equities.
An RRSP sounds like a great idea! Who is eligible to contribute to one?
Wondering if there’s an age restriction on your ability to contribute to an RRSP? Good question. You get to contribute to your RRSP up until the 31st of December of the year you turn 71, after which you have to convert the RRSP into a Registered Retirement Income Fund (RRIF) or lifetime annuity. Those who continue to have earned income after the age of 71 (and have spouses) can contribute to a spousal RRSP until the 31st of December of the year the spouse clocks 71. To accrue the benefits of an RRSP however, it is better to start investing in your RRSP early.
The maximum contribution for the RRSP is calculated yearly. For the 2020 tax year, the limit is less than or equal to 18% of the prior year’s income (i.e. your 2019 income) with adjustments made for your pension and any unused RRSP room up to a maximum annual contribution limit of $27,230 (compared to a maximum contribution limit of $26,500 for the 2019 tax year). The amount you contribute to your RRSP is tax-deferred.
If, for example, you earned about $60,000 in 2019, you can contribute as much as 18% of that amount, or $10,800, to your RRSP. That amount gets deducted from your total income so you would only have to pay taxes on $49,200.
When Can I Withdraw from my RRSP to Buy a Property?
With the Home Buyers’ Plan (HBP), you can withdraw from your RRSP to buy a property. One major condition is, however, that you qualify as a first-time home buyer. A first-time home buyer is someone who has not occupied a home owned by them or their spouse/common-law partner within a four-year period. This four-year period is calculated from the 1st of January of the fourth year before the year when you withdraw the funds and ends 31 days before you plan to withdraw your funds (e.g. if you withdraw the funds on April 31st, 2021, the four year period commences on January 1st 2017 and ends on February 28th 2021). You can draw up to $35,000 using the HBP with none of the regular consequences of withdrawing from an RRSP.
Other requirements before participating in this program (withdrawing money from your RRSP under the HBP) are that you need to be a resident of Canada and intend to occupy the home as your primary place of residence within a year of purchase. The good thing is you can participate in this program even if you have used it before. As long as you’ve completed your repayments by January 1st of the year you plan to use the HBP again, and fulfill the other requirements (including the first-time home buyer condition), you can withdraw using the HBP again.
For the HBP, you are allowed up to 15 years to make your repayments.
How an RRSP works in Canada: the relationship between your income, tax rate, and RRSP deductions
So you have an RRSP account. You still have to decide how much money to put in it! You have to contribute to it manually unless your employer does it for you. Even if you decide to contribute, you can wait a while before using the tax deductions on your taxable income. Contributions and deductions don’t have to occur in the same tax year. But how would you know what to do?
In Canada, RRSPs give you the benefit of deferring the taxes you would pay on the amount you contribute to a later point in time (such as during retirement). You don’t have to deduct your contributions from your taxable income at the same time you contribute; you can defer your deductions and take them at a later point in time. The most benefit would be gained if you deferred your income tax while you were in your highest tax bracket as you would save the most tax. Subsequently, if you think that you will make more money in the future, you might consider not to deduct your contributions now but to plan to take them when you have the most income.
The RRSP is not tax-free, however, unlike the Tax-Free Savings Account (TFSA). You will have to pay taxes when you eventually withdraw from your RRSP, and if you withdraw early you’ll be subject to high withholding taxes. But if you withdraw when you’re retired and don’t have much income, then you can pay much less income tax on your withdrawal than you would have if you had simply kept the money when you earned it.
A Practical Example
Let’s work with the assumption that you made roughly $60,000 in Ontario in 2019.
Your total (provincial plus federal) marginal tax rate with $60,000 would be approximately 29.65% (as you’d fall within the tax bracket of those who earn between $47,630 and $77,313).
If you do not make an RRSP contribution, you would be taxed on the entire $60,000 and your income tax for the 2019 tax year would be $14,328.
If you contributed 18% of your $60k income into your RRSP (approximately $10,000) and deducted the contributions from your income immediately, you would only have to pay an income tax of about $11,021 for the 2019 tax year. You could save up to $3000 in tax!
However, if you think you will be earning in a higher tax bracket in the future (e.g. if you’d be earning approximately $150,000 with a marginal tax rate of 46.41%), you can contribute now but delay your deductions until you are in a higher tax bracket, allowing you to effectively save more.
Now, let’s say you’re retired and withdrawing from your RRSP (or RRIF/annuity at that point). If you earned less than $43,906 (using today’s dollars), your marginal tax rate would be at an average of 20.05% (not including various tax credits). You would have to pay income tax on your withdrawals, but at a rate much lower than you would have paid on income when you were working.
Possible tax savings when contributing to an RRSP
|Your Earnings||Marginal Tax Rate||Tax Savings With a $10k Rrsp Deduction|
Taxes paid when withdrawing from an RRSP (not including old-age tax credits)
|Employment Income||Marginal Tax Rate||Tax on a $10k RRSP withdrawal|
You can compare the amounts you could save by contributing to an RRSP with the amounts you would have to pay when you withdraw your RRSP. If you’re currently in a high-income tax bracket and will be in a lower one when you retire and withdraw, then an RRSP can save you thousands. If, however, you’re not earning much right now in the first place, it might be better to save up your deductions for later or think about investing in a TFSA instead.
Summary: With an RRSP, you can save on tax from the highest bracket of your income (via deferred taxes) and make withdrawals when you are in your lowest income bracket (at retirement).
Have a spouse/common-law partner? How to take advantage of a spousal RRSP
Not only can you contribute to your personal RRSP, but you can also make contributions to your spouse’s RRSP account (or that of your common-law partner), and vice versa. Here, the contributing partner gets a tax deduction made for contributions made to the account up to the CRA limit of the contributing spouse/common-law partner. You can contribute until your partner gets to the age of 71 (even if you are over 71).
This type of RRSP works best if there is a large gap between the current income and/or expected post-retirement income of both partners. You can effectively move taxable income from the partner in the higher tax bracket to the one in the lower tax bracket to take advantage of larger deductions now or lower income taxes during retirement. It is also beneficial for couples with age differences.
However, one major thing to consider when building a spousal RRSP is the rule of attribution. This rule states that if money is withdrawn from a spousal RRSP, the contributing partner is taxed on the withdrawal if any spousal contribution had been made within two years of the withdrawal (e.g. if in 2020, you take money out of your RRSP, but your spouse has contributed between 2018-2020, your spouse would get taxed on that withdrawal). Thus, if the receiving spouse is nearing retirement or will have little or no income soon, it is best to make any contributions into the RRSP as early as you can within the tax year so that the spouse can withdraw as soon as possible without the additional penalty.
Most importantly, don’t wait until you/your spouse is close to retirement before working together on a spousal RRSP.
What can you have in your RRSP account?
Your RRSP account can consist of any combination of qualified investments, including cash, GICs, bonds, mutual funds, and listed stocks. Some RRSP providers have restrictions, however, limiting your choices to only a few options. But with a self-directed RRSP, you can choose your own types of investments and control how you want to invest. If you want to, you can have an investment manager or robo-advisor manage your self-directed RRSP for you.
For someone who’d like to diversify and invest in different companies and types of assets, a self-directed account provides you with consolidated statements in a single account, gives you access to a wide range of different investments including bonds, mutual funds and ETFs, and they are generally easier to manage. With freedom comes responsibility, and you should always make sure to make informed investments, even if you hire an investment manager. One final advantage of a self-directed RRSP is that they are much easier to convert to RRIFs after you turn 71.
If you are an active trader, an RRSP account can be extremely useful as all gains (and losses) in the account are deferred until the time of withdrawal. This means you can buy and sell assets like stocks without worrying about having to keep track of capital gains or pay taxes on your profits every year.
Some tips on how to take advantage of the RRSP program
- Apply to have your income tax withholdings reduced on your paycheck if you’re a regular contributor to an RRSP. This helps get money in your pocket rather than having to wait for a tax refund next year.
- Delay your contribution deductions if you expect to be in a higher tax bracket in the future to achieve greater tax savings.
- Filing tax returns for low-income earners in your family is a good idea, as this increases their future contribution room.
- If you and your spouse have different incomes, it is good for the partner with a higher salary to contribute to the RRSP of the one with the lower salary.
- If you plan to buy a property, you or your spouse may be able to take advantage of the Home Buyer Plan to get money for your mortgage downpayment.