RRSPs: The basics to get you started and if they’re right for you
Ready to start saving for your retirement? This article will explain the basics of RRSPs and whether or not they’re right for you. Of course with all financial advice, we highly recommend that you speak to a professional when planning your personal finances.
A Registered Retirement Savings Plan (RRSP) is one of the most popular ways Canadians save for their retirement. For many, RRSPs are synonymous with retirement savings (although there are other options, see below).
An RRSP is an account registered with the Canadian government that offers certain tax benefits over other investment accounts.
Canadians set up RRSPs through a bank, credit union, financial planner or insurance company.
An RRSP is an investment account – not an investment in itself. It can hold many different types of investments including mutual funds, stocks, bonds and GICs.
Once you’ve opened an RRSP, you can either work with an advisor to determine what investments you will contribute to in your RRSP, or do it yourself via a self-directed RRSP.
How do they work?
Unlike a regular investment account, the contributions you make to your RRSP will not be taxed by the government until the funds are withdrawn down the road. Investments are able to grow and compound tax-free. Because most people will be earning a lower income in their retirement, the taxes they pay on the funds withdrawn from an RRSP tend to be lower than during their peak earning years.
“Ideally, you make RRSP contributions when you are in a higher tax bracket and withdrawals when you are in a lower one,” said Bruce Barran, CPA, CA, a partner with Davis Martindale LLP.
Contributing to an RRSP also provides Canadians with tax credits on their annual income tax returns.
The tax benefits offered by RRSPs are the government’s way of encouraging Canadians to save for their retirement. “Government pensions are not enough to retire on,” said Barran. “You need to plan ahead for retirement and RRSPs are a good retirement savings vehicle.”
The government wants you to use your RRSP for retirement, not vacations and shopping sprees. To this end, provisions are in place that make it costly to make early withdrawals from your RRSP.
What are the rules?
The deadline for contributing to an RRSP for the 2014 tax year is March 2, 2015.
Over your lifetime, you can contribute to your RRSP until Dec. 31 of the year you turn 71.
The amount you can contribute for a given tax year, called your RRSP deduction limit (also referred to as your contribution room), can be found on last year’s Notice of Assessment (NOA) – it equals 18 per cent of your earned income for the last year, up to a maximum of $24,270.
Any unused contribution room from previous years is carried forward (as long as you didn’t make an early withdrawal from your RRSP).
If you over-contribute to your RRSP by more than $2,000, you’ll have to pay a tax of one per cent on your excess contributions.
If you don’t have your NOA you can call the Canada Revenue Agency or use their online service.
Although the deadline for RRSP contributions is often trumpeted as a crucial date, it’s advised that you contribute to your RRSP throughout the year, instead of just at deadline. Setting up an automatic contribution plan with your provider allows you to get into the habit of saving for your retirement throughout the year. You can make smaller, regular contributions (rather than one lump sum), which allows you to take advantage of dollar-cost averaging.
There are many other scenarios surrounding RRSPs including on spousal and group RRSPs, how to transfer funds and make withdrawals, which are addressed on the CRA’s website.
Is an RRSP right for me?
A big reason for opening an RRSP is to take advantage of the tax benefits it provides. The funds you contribute will not be taxed as income until they are withdrawn (ideally when you retire in a lower tax bracket). Income that is earned within the RRSP accumulates tax-free.
Another major benefit of RRSPs is that you receive tax credits for the amount you contribute (up to a limit).
RRSPs make sense in a variety of scenarios.
For one, contributing to an RRSP is a structured way to actively save for your retirement. Because the early withdrawal penalties are so stiff, you may be less tempted to borrow from your RRSP for purchases other than retirement, buying a home and paying for your education.
Because RRSPs are tax-deferred, it makes sense to contribute to one during your peak earning years when you’re in a higher tax bracket, if you expect to be in a lower tax bracket when you retire.
Young people just beginning their careers (who are likely in a lower tax bracket) still may want to open an RRSP as soon as possible. Starting out early means you can take advantage of your investments compounding over time.
“The earlier you start saving for retirement, the earlier your money can start compounding and the longer you’ll have it working for you,” said Gregory Clarke, CPA, CA, partner with SB Partners LLP.
“The best reason to start an RRSP early is that it gets young people into the habit of saving,” said Clarke. “Even if it’s a couple hundred dollars a year, it helps create a mindset that saving is important.”
When RRSPs don’t make sense
If you expect to stay in a low tax bracket for the duration of your career, RRSPs might not be for you. At retirement, the tax benefits you receive will be small compared to those who worked in a higher tax bracket while contributing to their RRSP.
Moreover, low income earners could have other government benefits, like the Guaranteed Income Supplement, clawed back if their RRSP exceeds the maximum income requirement.
Tax-Free Savings Accounts
An alternative to RRSPs that is rising in popularity is the Tax-Free Savings Account (TFSA).
TFSAs were launched in 2009, open to Canadians ages 18 and up. Funds grow in your TFSA tax-free and withdrawals can be made at any time (also tax-free).
There is a maximum contribution amount that you’re allowed to put in and any unused contribution room is carried forward.
TFSA contribution limits:
- 2009 $5,000
- 2010 $5,000
- 2011 $5,000
- 2012 $5,000
- 2013 $5,500
- 2014 $5,500
- 2015 $5,500
There are, however, rules on when you can put withdrawn money back into your TFSA to be aware of. If you go over your maximum contribution amount you could face a one per cent tax penalty.
Company pension plans
Almost all Canadians in the workforce over the age of 18 contribute to the Canada Pension Plan (CPP), however some may also have access to pension plans offered through their employer.
The Average Joe shouldn’t expect a company pension plan to fully cover their cost of living during retirement, but, in addition to your personal savings, they can help finance your retirement.
According to data from Statistics Canada, just 38 per cent of all employees were covered by a registered pension plan (RPP) in 2012 (the latest data available).
The two main types of company pension plans are Defined Benefit pension plans (DB plans) and Defined Contribution pension plans (DC plans).
With DB plans, your employer agrees up front to pay you a set amount of money each month after you retire and it’s up to the company to make sure the money is there down the road.
With DC plans, your employer will agree to contribute a certain amount of money to the plan on a regular basis. When you retire you’ll receive all of the funds your company contributed, all of the funds you contributed, plus any interest made.
With DB plans, the risk is on the employer to make sure the money is there. With DC plans, the onus is on the employee to invest the funds – the risk is on them. It’s not surprising then to note that DC plans are rising in popularity among employers.
According to StatsCan, of all employees covered by RPPs in 2012, 71.5 per cent were in a DB plan – compared to 84 per cent a decade earlier. Membership in DC plans continues to rise, up by 2.7 per cent in 2012 to account for 16.7 per cent of all RPP membership.
Note: This feature is for expository and informational purposes; it is not meant to be taken as personalized or expert financial advice.
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