Written by Dan Bick and Letitia Fluit
A Registered Retirement Savings Plan (RRSP) is one of the few investment accounts available in Canada that offers tax incentives. With an RRSP, you can save significantly on pre-tax dollars. Yet Statistics Canada shows that roughly 4 out of 5 Canadians don’t contribute to an RRSP.
For you and others you know, there can be many reasons for not contributing. You may feel that it’s hard to prioritize saving over your everyday expenses, or that you don’t earn enough money to make contributing to one worthwhile. Maybe you have TFSA in place for savings and investments and feel that it’s accruing enough on its own.
We understand that it can be challenging to grasp the actual value of each and every investment tool out there. This post aims to clear up any confusion you might have about RRSPs, covering the most important points that we cover with our clients.
How do RRSPs work?
In 1957, the Canadian government introduced RRSPs to motivate Canadians to save for retirement by offering tax incentives.
But before we get “into the weeds” on what these incentives are, let’s make sure we’re all on the same page first.
Here are the basics on how RRSPs work:
- All RRSP contributions are tax-deductible, which means that whatever contributions you make to your RRSP are taxed at a later date (when you withdraw them from the RRSP) rather than today.
- The total amount you can contribute depends not only on your limit for this year but also on how much you have contributed in previous years. The unused portion remains available from past years. To find out what contribution room you have available, check the assessment notice the CRA sent you last year, which you should have received after your tax return was processed.
- The RRSP contribution limit is based on 18% of your earned income up to the annual government limit for that tax year.
- The maximum amount you can contribute — the “ceiling” — rises every year. 2019’s ceiling was $26,500, while 2020’s is $27,230.
- The deadline for RRSP contributions is 60 days after the calendar year-end.
What are the tax advantages of RRSPs?
RRSPs come with some major advantages when compared to other investment account types. Each of these advantages can offer benefits, such as…
- Keeping more of your income available for today — Because RRSP contributions are tax-deductible, you’ll have more income available for your everyday expenses.
- Your savings will grow tax-free — We call this “tax-deferred growth,” which essentially means that you won’t pay tax on any investment earnings so long as the earnings stay in your RRSP. As the earnings compound, your savings grow much faster. (Keep in mind, however, that you will pay tax on your earnings once you withdraw.)
- You pay yourself first, rather than the government — With an RRSP, you can invest more of your money immediately, instead of paying the government and investing less. In scenarios where you have a lot of time for the investment to grow, RRSPs can be an excellent choice.
How do I get the most out of my RRSP?
The effectiveness of your RRSP is largely within your control. To get the most out of the RRSP, you’ll ideally deposit money when your tax rate is high and withdraw it when your tax rate is low.
Think about it this way. If you contribute during high tax years and then spread your withdrawals out over a long time in retirement, you can minimize tax paid. Let’s say your marginal tax rate is 50% right now and is something like 20% in retirement. By using the RRSP, you can essentially get a 60% gain on your money before investment returns.
How much can my RRSP earn over time?
To illustrate how much your RRSP can earn over time, let’s compare two similar accounts with different years of growth.
These are nearly identical accounts, but one had an additional decade to grow — and comes out ahead with almost double the earnings. This is an excellent illustration of how drastically your investments and earnings can compound over time. The sooner you can put money aside, the more time it has to grow. Try calculating your own earnings with our RRSP calculator.
Each year, your financial situation may be a little different than the last one. Making sure you adjust your financial plan for these changes can be another task to add to your already full plate of responsibilities. But if you expect to make more money now and spread out your income during retirement, it makes sense to choose an RRSP. To get started on a strategy and plan for your retirement savings, schedule a meeting with one of our advisors today.