One way for a Canadian to preserve her lifestyle and not run out of money in her golden years is the Registered Retirement Savings Plan (RRSP,) which is a retirement savings and investing vehicle for both the self-employed and those employed by others in Canada.
During your working years, you place pre-tax cash into the RRSP and that money grows tax-free until you withdraw it at retirement. At that time, the money is taxed at a marginal rate. While this characteristic and others make the Canadian RRSP similar to a 401(k) plan, there are some major differences – and some RRSP advantages and disadvantages – to consider.
RRSP Principal Growth
The only guarantee that accompanies an RRSP is that the cash you use to fund the investment vehicle will compound tax-free. As with any investment, the monetary growth of the savings plan depends on the economy, the wisdom of its manager and the investment strategy employed to manage the account. Consequently, the mere existence of the fund is no guarantee that its owner will retire and live a luxurious life.
The RRSP Tax Benefits
The Registered Retirement Savings Plan was created in 1957 when the Canadian Income Tax Plan was passed by the country's Parliament. In turn, the Canada Revenue Agency (CRA) governs the plan's annual contribution limits, the timing of the contributions as well as the assets a worker can use to grow her wealth.
Under the rules of the RRSP, a worker's plan contributions offset her income when she files her taxes. For instance, if you are a taxpayer whose tax rate is 30 percent, a $100 contribution to an RRSP will save you $30 at tax time. You receive this tax benefit for each contribution you make up to the contribution limit set by the CRA.
RRSP Tax Advantages
The money you maintain in your RRSP account is tax-deferred, meaning it's not taxable until its withdrawal from the account. Once in the account, those dollars are, in effect, exempt from the capital gains tax, dividends tax and income tax. When left in the account, the contributions compound on a pre-deferred basis.
If you are an RRSP contributor, the Canadian government delays the calculation of your tax bill until the time that you withdraw the account's principal. If you delay that withdrawal until your retirement age, your marginal tax rate at that time may be lower than that during your working years. Consequently, you will owe the government less and you keep more with which to enjoy your retirement years.
Cons of RRSP
The best way to protect your retirement investment is to make smart decisions and define a rational investment strategy. For Canadians, this requires that you recognize the cons of RRSPs.
The maximum amount that a taxpayer can invest in a registered retirement savings plan and be able to deduct that investment from that year's income tax is 18 percent of the prior year's earned income. The contribution is further limited by a cap that's set by the CRA.
Failure to Consider Alternative Investments
Like all tax-deferred investment vehicles, the CRA limits the investor's options when she commits funds to the plan. Depending on a number of factors, a worker might earn a higher return net of taxes if she elected an alternative investment.
Contributing Maximum Amount Despite Circumstances
While a worker can contribute less than the allowable maximum, the inclination for many is to contribute the maximum allowable amount despite life circumstances. At first glance, this approach appears to be in the taxpayer's best interest in that it minimizes, to the degree possible, the income that's subject to personal income tax.
A problem arises if, due to the failure to budget properly, RRSP contributions must later be withdrawn to address high-interest credit card bills that grew in part due to the worker's effort to maximize her RRSP contribution despite her present financial circumstance.
RRSP Withdrawal Is Ordinary Income
Any cash you deposit in an RRSP is treated by the Canadian tax code as ordinary income. In some cases, this treatment is to the taxpayer's disadvantage. For instance, when held in an RRSP, qualified dividends and long-term capital gains are taxed at the taxpayer's marginal rate. If held outside the RRSP, long-term capital gains and qualified dividends receive favorable tax treatment, meaning the tax rate applied to them is lower than that which applies to ordinary income.
RRSP Impact on Income-Tested Benefits
It's possible that your RRSP withdrawals will decrease the amount of the government benefits that you receive in your retirement due to clawbacks on Old Age Security (OAS) or the Guaranteed Income Supplement (GIS.)
For instance, during the period July 2021 to June 2022, an income of $79,054 or higher triggers an OAS clawback. This means your OAS benefit is decreased by 15 cents for each $1 you receive above the income threshold, which equates to an effective 15 percent tax rate.
Income-Based RRSP Contributions
Ideally, your contributions to an RRSP consist of pre-tax dollars. If, however, you fund your annual contribution with post-tax dollars, you receive a tax refund at the end of the year when you file your tax form.
Unfortunately, if you spend your tax return, rather than save it, you are effectively taxed twice: You are taxed both when you spend the refund and then when the government assesses tax on your RRSP withdrawal.
- Government of Canada: Registered Retirement Savings Plan (RRSP)
- Justice Laws: Income Tax Act
- Government of Canada: Definitions of RRSPs
- Government of Canada: Setting Up An RRSP
- Plan Easy: The 7 Drawbacks of RRSPs
- Savvy New Canadians.com: Retirement Benefits: 10 Strategies To Minimize the Old Age Security (OAS) Clawback
Billie Nordmeyer is an IT consultant of 25 years standing. As a senior technical consultant for SAP America and Deloitte Touche DRT Systems, a business analyst, senior staff, and independent consultant, Billie has worked across the retail, oil and gas, pharmaceutical, aeronautics and banking industries. Billie holds a BSBA accounting, MBA finance, MA international management as well as the Business Analyst and Software Project Management certificates from the Cockrell School of Engineering at the University of Texas at Austin.