RRSPs And The Need To Know Basics
Estimated reading time: 7 minutes
Saving for retirement is good, and RRSPs (Registered Retirement Savings Plans) are a popular tool.
Today, guest contributor investment advisor Garry Gorr answers a CBB reader question and explains RRSPs and the need-to-know basics.
Understanding RRSPs: The Basics
Reader Question: I want to save for retirement. Where is the best place to save for this? I have been told NOT to use RRSP. Can you help?
Client Predictions
I don’t know the client’s age or income, so this answer is predicated on the client having several months of income in an emergency fund.
An emergency fund is a base component of proper planning and should be done before making any RRSP contributions.
Also, it assumes the client makes more than $40,000 in annual income, as incomes under $40,000 don’t benefit much from tax savings on RRSP contributions.
Below I will try to define some of the RRSPs’ Basics and illustrate some of the long-term advantages.
When Did RRSPs Begin?
RRSPs first existed in 1957 as a government-supported effort to help Canadians save for retirement.
Three Types of RRSPs
There are three main types of RRSPs
1. Individual RRSPs
An individual RRSP is where the contribution is made and held in your name.
2. Spousal RRSPs
You contribute, deducted by you, but held in your spouse’s name.
This strategy would be employed when you are the higher income earner and likely in retirement.
The payout would be taxed in the spouse’s hands, resulting in less tax payable.
3. Group RRSPs
The contributions are payroll deducted and forwarded to the investment manager of the group RRSP and invested as per your directions in your individual account.
One key difference is that tax savings can be realized immediately if documented properly rather than waiting until the end of the tax year.
How Much Can I Invest In My RRSP?
You Can Invest 18% of the prior years “earned income” minus any pension adjustments (P.A.) up to a yearly maximum.
Contributions made to a Pension Plan where you work, by you and your employer, would be an example of a P.A. and reduce your RRSP contribution amount.
As outlined by the Canada Revenue Agency page, the RRSP dollar limit for 2023 is $30,780
This maximum will be indexed annually by the annual increase in the average wage.
Canada Revenue shows how much you can contribute annually on your Notice of Assessment.
What if I can’t contribute the maximum I am allowed into my RRSP?
Good news!
The unused amount not claimed is carried forward and never lost.
CRA keeps track and shows the unused amount that can be claimed in future years, either in whole or in part, on your Notice of Assessment and is not limited to 18% of your current income.
What Kind of Investments Can I have in my RRSP?
People often say I will buy an RRSP as if it were an investment. It is just a holding vehicle for certain types of investments.
Some of the most common investment types are:
- Cash
- Guaranteed Investment Certificates (GICs)
- Savings Bonds
- Treasury Bills
- Bonds
- Mutual Funds
- ETFs (Exchange Traded Funds)
- Canadian Mortgages
- Equities
- Income Trusts
The type you choose for your RRSP depends upon many things.
One should consider your risk level, investment time horizon, and the return you might require to achieve your financial objectives for retirement.
A good planner can help you build a retirement plan, answer these questions, and help you decide your suitable investments.
The Main Advantages of an RRSP
- Contributions are tax-deductible, resulting in less current taxable income.
- Investment earnings grow on a tax-deferred basis.
How important is the tax deferral aspect of RRSPs?
To see how important it is, let us compare a 35-year-old saving $7,000 per year into an RRSP versus the same $7,000 being saved in a taxable investment and being taxed annually at 40%, both investments earning 7%.
After 30 years, the Registered Investment has a value of $707,511.
The non-registered investment is worth $423,022.
The non-registered investment was worth less every year, as 40% of the investment earnings were lost to taxes.
Granted, the registered investment has had zero taxation in the accumulation period.
This is the real magic of tax-sheltered growth and will be subject to taxes when income is withdrawn.
Usually, in retirement, most Canadians will be in a lower tax bracket than during their peak earning years, and the income will be taxed at a lower tax rate.
Even if we assume the client took the money in 1 lump sum at 65, not likely or recommended, and paid tax at 40%, the net after taxes would be $424,507, effectively the same as the non-registered plan.
Reinvesting Tax Savings
What if the Investor Reinvested their Tax Savings every year?
This has a profound impact on the size of your accumulation!
The tax savings on a $7,000 deposit produces an annual refund of $2,800 ($7,000 times 40%).
If this were invested outside an RRSP, it would produce an additional $169,209 of capital. The combined capital total at 65 would be $876,720.
All investors should consider reinvesting the tax savings to magnify the accumulation.
Benefits Of Investing In RRSPs Early
If the client waits five years to begin investing and starts at 40 versus 35, they will accumulate only $598,567 (assuming they reinvest tax savings).
A significant difference proves the old axiom that starting early has substantial advantages.
Withdrawing RRSPs Early
Your RRSPs are Not an Emergency Fund
Investors can withdraw funds from their RRSP and sometimes do, but seriously the consequences are more severe than you might imagine.
If you withdraw, a withholding tax is levied based on the withdrawal size.
This is applied to income tax owing, as the withdrawal is 100% added to other income in the year of withdrawal.
2012 Withholding Tax Rates On Withdrawals
| Withholding Tax Rates on Withdrawals | ||
| Withdrawal Amount | Rate | |
| 0 to $5000 |
10% | |
| $5,001 to $15,000 |
20% | |
| $15,000 and over |
30% | |
2023 Withholding Tax On Withdrawals
Your financial institution withholds the tax when you withdraw funds from an RRSP.
The rates depend on your residency and the amount you withdraw. For residents of Canada, the rates are:
- 10% (5% in Quebec) on amounts up to $5,000
- 20% (10% in Quebec) on amounts over $5,000 up to including $15,000
- 30% (15% in Quebec) on amounts over $15,000
There will also be provincial tax withheld for funds held in the province of Quebec.
Contact your financial institution or Revenu Québec for more information on Quebec withholding.
For non-residents of Canada, withholding is 25% unless reduced by a treaty.
Example
The real cost is the long-term cost.
A male age 35, investing $7,000 per year at 7%, and wanting to retire at age 65, currently has $50,000 of accrued RRSP savings.
After ten years, he withdraws $25,000 to deal with a critical illness.
What impact will this have on his future savings?
Impact of a withdrawal from RRSP Withdrawal Calculator.
The result is very significant, as you can see.
When Not To Use An RRSP
To answer the final piece of this investor’s question where they have been advised not to use RRSPs.
There are a few circumstances where an RRSP doesn’t make sense.
However, low-income Canadians, or Canadians with expensive debt, or those without an emergency fund would be advised to tackle debt first and build an emergency fund before investing in an RRSP.
This is not a comprehensive overview of RRSPs but focuses on the Need to Know information.
Every attempt has been made to be accurate, but Errors and Omissions are Excepted (E&OE)
Now that your literacy has improved the next step is to find an advisor to help you begin the process of retirement planning.
Discussion: How old were you when you started to invest?
Contribution Post By: Gary GorrI am an investment advisor employing behavioral finance principles in my advice-giving and a licensed life insurance broker with 36 years of experience helping Canadians achieve financial security. CONTACT INFORMATION: (905) 202-8430 ext.626
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