April might hold the dubious distinction of “tax month” in Canada, but around February many Canadians start their tax preparation with an eye to retirement planning. Why?
The answer revolves around Registered Retirement Savings Plans, or RRSPs. These special accounts come with strict limits on when and how much you can contribute, with the deadline for contributions allocated to the 2022 tax year only weeks away.
While retirement for some could still be many decades away, experts say that doesn’t mean saving and planning for that day isn’t a young person’s game.
In fact, taking advantage of an RRSP’s compounding interest features is in many ways suited for those with plenty of time to save, says personal finance expert Rubina Ahmed-Haq.
“Ideally, you want to be saving money now for 25, 30 years from now so that your money has time, your investments have time for all the ebbs and flows of the market to get all the dividends to continue to grow over time, rather than trying to time the market of when to get in and out,” she says.
While that may be true of many investment vehicles, Ahmed-Haq says the RRSP is especially popular because it’s “the most tax-efficient way to save for your retirement.”
So, what is an RRSP? Why is it so “tax-efficient?” And why is there a deadline? Here’s all you need to know to get started on your retirement savings.
What is an RRSP?
An RRSP is an account that’s registered with the Canada Revenue Agency. In it, you can hold investment products like GICs, mutual funds, bonds or use it just as a regular savings account. It’s available to anyone under the age of 71.
What’s important about an RRSP is that any money you put into the account is no longer counted as income for you in that tax year. If you make $56,000 and put in $6,000, only $50,000 will be taxed for you as income for the year.
While the overall amount you’re taxed is less, an RRSP can also help lower the rate you pay on those taxes. This is because in Canada, different amounts of income are taxed at different rates — lower incomes are taxed less than higher amounts.
For example, in Canada this year, anything less than $50,197 is taxed at a rate of 15 per cent, while anything you make above, up to $100,392, would be taxed at 20.5 per cent.
So, continuing with the above example, because you struck that $6,000 from your taxable income this year, you will be taxed at a lower rate.
“The thing we’re trying to do here is to get a lower tax rate,” says Nathalie Lagace-Albert, a certified financial planner with the National Bank of Canada.
Now, what’s the catch? Well, you’re going to have to pay tax on that amount eventually when you withdraw it from your RRSP. Anything you earn on the investments, however, remains tax-free while inside the account.
The goal here is usually to make these withdrawals when you’re making less than you were when the money went in, says John Yanchus, director of tax and estate planning at Canada Life.
“Later on in life, hopefully, your tax bracket in retirement would overall be lower than it is today or as you’re putting those contributions in,” he says. “So the overall plan really is to put contributions in while your income is higher or your tax rate’s higher and then pulling it out when it’s lower.”
Let’s wrap up the example: say you make a withdrawal of $6,000 from your RRSP at age 65, but your income at that time is only $44,000 with a modest pension and some part-time work.
Now, your taxable income for that year is again just $50,000 — a bit higher than it would’ve been, but you’ve successfully avoided paying the higher tax bracket rates.
When is the RRSP deadline and how much can I contribute?
Because RRSP contributions directly affect how much you’re taxed for the year, there has to be a cut-off ahead of the income tax filing deadline, which falls on April 30 this year.
This RRSP deadline is always 60 days into the calendar year, Yanchus says.
“It gives you a little bit of a window to do that income planning and to try to figure out where you’re at and if an RRSP contribution and a deduction would help you in that planning,” he says.
This year, the RRSP deadline is March 1. Yanchus notes for leap years, that the 60-day deadline would land on Feb. 29.
There are limits to how much an individual can contribute to an RRSP annually, which is affected by how much you’ve earned as well as considerations from a pension and a few other factors.
The simplest way to find your own contribution limit is to check your CRA My Account. The maximum amount anyone can put into an RRSP in 2023 is $30,780.
Unused contribution room won’t go away and can be used up in future years.
Each year, your allowable RRSP contributions will grow according to 18 per cent of your earned income from the prior year, plus or minus a few adjustments.
If you end up contributing more than $2,000 over your deduction limit in a year, you’ll generally pay one per cent tax per month on the excess.
How else can I use an RRSP?
Money saved in an RRSP doesn’t just have to go towards retirement.
The account has two offshoots that will allow Canadians to save for buying a home and for additional education, if they wish.
The withdrawal limit for the Home Buyers’ Plan is $35,000. This money can go towards qualifying for a mortgage on a new home as well as for the down payment.
The catch is that you have to start paying back this money the second year after you withdraw it, contributing back a portion of the total amount over 15 years. If any of these payments are missed, it’ll count as income on your taxes that year.
The Liberal government also promised to introduce an alternative path to saving for first-time homebuyers, with a new tax-free account scheduled to roll out later this year.
The Lifelong Learning Plan works in largely the same way as the Home Buyers’ Plan for those going back to school full-time, but it comes with a limit of $10,000 in withdrawals per year and an individual can’t take out more than $20,000 in total. The repayment time frame is 10 years.
Yanchus notes an RRSP can also be used as a form of income splitting between you and a spouse, either a married or common-law partner. If one member of the relationship makes more than the other, they can make spousal contributions to an RRSP and have the other partner make the withdrawal, potentially offsetting the overall tax rate paid on the total income.
Lagace-Albert says RRSPs can also be appropriate places to hold emergency funds.
In the event of an unexpected job loss, an RRSP holder might suddenly find their income for the year is drastically lower than they had been planning. Making an RRSP withdrawal at this point, then, could make sense for someone with savings to draw down while able to pay a much lower tax rate than they would have normally, she says.
How do I cash out an RRSP?
Individuals can make withdrawals from their RRSPs at any time. This amount will be subject to a withholding tax, however, and will then be counted against your income tax for that year.
Yanchus notes withdrawing your entire RRSP once you retire is therefore not usually advised from a tax perspective.
Even if you don’t consider yourself retired, your RRSP must mature by Dec. 31 in the year you turn 71.
There are a couple of options at that point.
You could buy an annuity from a life insurance company, which will deliver a steady and predictable stream of payments through your retirement until your death.
Alternatively, you could convert your RRSP into a Registered Retirement Income Fund, or an RRIF. The RRIF is transferred to a bank or other holding company that typically keeps the money invested in the stock market or other products, allowing your wealth to remain exposed to the market and possibly keep growing.
You’ll get payouts from the RRIF through your retirement, but it’s more prone to market fluctuations than the predictability of an annuity.
“The RRIF and the annuity options basically turn your RRSP into an income stream to support your lifestyle through retirement,” Yanchus says.
“An annuity … gives you a level income or a level payment for the rest of your life. Whereas with an RRIF, you can still control the investment. So it’s got a little bit more flexibility in terms of what you’re invested into and what you want to see out of that and your risk tolerances.”
Is an RRSP right for me?
There are “sweet spots” in your career where an RRSP will deliver the most bang for your buck, Yanchus notes, with high-income earners seeing the most relief from a well-timed RRSP contribution.
Oftentimes, lower income earners might find more benefit from contributing to a Tax-Free Savings Account (TFSA), he says. By putting savings here when in a lower tax bracket, you’re not forgoing the biggest savings potential of an RRSP, he notes.
There’s also no withholding tax on withdrawals from a TFSA, which Yanchus says makes it a more “flexible” account that some younger Canadians might find useful when saving for milestones earlier in their career like buying a home.
But he says he also believes the RRSP remains a solid option for anyone looking to grow their wealth without immediately paying taxes on earnings.
“I think it’s a great savings vehicle, it’s a great source of retirement savings,” Yanchus says.
While many of the benefits of an RRSP come for those in their highest earning potential, Lagace-Albert argues that younger workers just starting out in their careers can make good use of the savings vehicle as well.
In addition to earning compounding interest over a longer investment horizon, tax deductions from RRSP contributions can be deferred to later years — they don’t necessarily have to be utilized in the same year you make the contribution.
“You might want to use it in a later year when you know your income tax bracket is going to be higher,” she says.
Lagace-Albert also says people get stressed about trying to find a big chunk of money to contribute to their RRSP before the deadline, but this might not be the ideal way to save for retirement.
She recommends clients set up automatic contributions instead, which is easier to factor into monthly budgeting and allows individuals to more evenly spread their investments across market fluctuations.
Ahmed-Haq agrees, and says the best way to use an RRSP is not just about lowering your tax bracket in February, but making contributions a regular aspect of your financial planning.
“It’s about really flexing that savings muscle, making sure you stay in the habit of saving,” she says.