Starting and building a Registered Retirement Saving Plan (RRSP) will likely be one of the most important steps you take in your financial life. There is simply no better way to cut your tax bill and save for the future. Here are all the answers to your RRSP questions…and some advice on how to make the most out of this valuable financial tool:
* What is a RRSP.
* What are the benefits of a RRSP?
* Why are RRSPs such a powerful saving tool?
* How much can I put into a RRSP?
* How is earned income calculated?
* When can I make a contribution?
* When is the deadline for making a contribution?
* What happens if I can’t contribute my full allowable amount?
* Can I take money out of my RRSP?
* How old do I have to be to have a RRSP?
* How long can I have a RRSP for ?
* What are my options when I have to close my RRSP?
Want to learn more about maximizing your RRSP?
Need help choosing the right combination of investments inside your RRSP? Try our asset allocation questionnaire. It will help you understand your risk tolerance and optimal investment mix based on your unique needs.
What is a RRSP?
It’s not uncommon to hear people refer to a RRSP as an investment. You’ll hear, “I’ve got some money in Canada Savings Bonds, in mutual funds, and in a RRSP”. Unfortunately, that’s a common mistake. It’s important to understand just what a RRSP is and isn’t in order to ensure you’re making the best use of them.
What a RRSP isn’t is a specific investment.
A RRSP is really just a special investment holder or account, or, if you like, piggy bank. You can hold a great variety of different investments inside the account. You can even hold many different types of investments inside the same RRSP.
What makes a RRSP special is that in return for agreeing to leave the money inside the plan.
you get two tax benefits – first, you can move some of your income into a RRSP without it being taxed. Second, once inside a RRSP the money grows tax-free.
What are the benefits of a RRSP?
RRSPs have two major advantages:
* Tax-deferred contributions.
* Tax-sheltered growth.
If you contribute income to a RRSP, you don’t have to pay tax on that money. For instance, say you make $75,000 per year. If you contribute $5,000 to a RRSP, you can deduct $5,000 from your taxable income for that year. You save the tax you would normally have had to pay on that $5,000.
Once you have money or investments inside a RRSP, they can earn profits for you without being taxed while inside a RRSP, interest, dividends, and capital gains you make on the money inside your plan aren’t subject to any tax. All your profits can go back to work for you.
Why are RRSPs such a powerful tool for saving?
Once you add the power of tax-free compounding to tax-deferred contributions you have a real money-making machine. To show you just how powerful RRSPs are, let’s compare the different outcomes of investing $5,000 of your income inside and outside a RRSP. Assume your income is $75,000, which puts you in the top-tax bracket.
Investing outside a RRSP
Suppose you wanted to invest $5,000 of your salary. If you didn’t use a RRSP, you’d first have to pay tax of up to almost 50% (depending on your province of residence). That leaves you with $2,500 to invest.You then invest the money in an equity mutual fund. Suppose your money is 100% in stocks, and you earn a 10% pre-tax profit, all of which is in capital gains. Capital gains are taxed at half your marginal tax rate, or 25%. Assume you sold your investment a year after you bought it, you would lose a quarter of your profits. This means that you really only made an after-tax return of 7.5%. If you continue to buy and sell investments in each year for 20 years, the original $2,500 investment would be worth almost $11,000. To learn more about compounding, click here.
Investing inside a RRSP
If you invested $5,000 of your salary in a RRSP, you would be ahead right off the start. You could put the full $5,000 to work, as it wouldn’t be taxed.Once inside your plan, any profits you make also aren’t taxed. If you earn an average of 10% a year in the stock market, you would be able to enjoy a 10% average annual compound return. After twenty years you would have over $33,000. That’s 3 times the savings you’d have investing outside a RRSP.If you take the money out of your plan, it’s taxed. But even assuming it’s all taxed at the 50% marginal tax bracket, it would still be worth almost $17,000. That’s still over 1 ½ times the savings you’d have investing outside a RRSP.
The RRSP edge
Investing inside a RRSP is hands down the better option. First, using pre-tax dollars means you have more money working for you. Second, your savings grow faster because you can reinvest all your profits without paying tax.
In our example above, saving $5,000 of your salary in a RRSP means that after 20 years, you’ll have 50% more saved up. Instead of the almost $11,000 you’d have if you hadn’t used a RRSP, you would have nearly $17,000, or an extra $6,000!
How much can I put into a RRSP?
There are three factors that affect how much you can contribute to a RRSP:
* A percentage of your previous year’s earned income
* A maximum dollar contribution
* An adjustment for your pension
A percentage of your previous year’s earned income
Each year you are working, you earn the right to contribute up to 18% of your gross income (technically, your earned income) to a RRSP in the next year.
For example, say you made $60,000 before taxes in 2001. That earns you the right to contribute up to 18% of $60,000, or $10,800 to your RRSP in 2002. (The most you can contribute is the lower of $13,500 and 18% of your previous year’s earned income.) However, if you haven’t used up your contribution room from previous years, you can contribute more than the maximum. For more about unused contribution room,
So just what is your earned income?
If you are an employee, this is generally your salary – the gross amount you make before deductions. If you are self-employed or are an active partner in a business, it also includes any business income. For the details on just what is – and isn’t – deemed to be earned income, click here.
A maximum dollar contribution
The most you can contribute in a year is $13,500, up to and including the 2003 tax year. For 2004, the dollar limit will be increased to $14,500, and for 2005, $15,500. After that, the dollar limit will be indexed, rising at the same rate as the cost of living.
An adjustment for your pension
If you belong to a pension plan, this will also affect how much you can contribute to a RRSP. First, the government starts off with your allowable contribution – currently $13,500 – or 18% of your previous year’s earned income, whichever is lower. Then it deducts an estimate of the increased value of your pension during the previous year. In other words, the more both you and your employer contribute to your pension plan, the less you can put into to a RRSP.
The amount used to represent the value of the pension contribution is called your pension adjustment, or PA. So your allowable contribution becomes the maximum contribution allowed or 18% of your previous year’s earned income, whichever is less, minus your pension adjustment.
How is earned income calculated?
Here are the details on just how Canadian Customs and Revenue Agency (CCRA) determines what your earned income is.
Earned income includes:
* Your salary.
* Net income from self-employment or being an active partner in a business.
* Research grants (after deducting any related expenses).
* Royalties from works or inventions.
* Taxable alimony and maintenance.
* Taxable child support payments.
* Net rental income (rents less any deductible rental expenses).
* CPP/QPP disability pensions.
Earned income is reduced by the following:
* Any deductible alimony, maintenance, and child support payments you make.
* Most deductible employment-related expenses, such as union dues and travelling expenses.
* Rental losses.
What’s not included as earned income?
* Interest income.
* Capital gains.
* Pensions benefits.
* Retiring allowances.
* Severance pay.
* Death benefits.
* Withdrawals from a RRSP or RRIF (Registered Retirement Income Fund).
* Payments from a deferred profit-sharing plan.
When can I make a contribution?
You can make a contribution to a RRSP any time you wish as long as you have some contribution room available. Contribution room available simply means you have earned the right to put some money into a RRSP that you haven’t yet entirely used up. You can put a full year’s contribution in at one time, or sporadically, as money becomes available. You can also arrange to have a set amount taken off your pay cheque every pay period and put into your plan.
When is the deadline for making a contribution?
The deadline for RRSP contributions is the sixtieth day following the tax year. For instance, the RRSP deadline for the 2001 tax year is March 1, 2002.
It’s important to realize just what this means. First, it isn’t the deadline for when you have to make a contribution. You can make a contribution any time you wish, as long as you have some contribution room available. The deadline is simply the date by which you have to make a contribution if you want to claim a deduction for it in a specific tax year.
For example, say you wanted to be able to deduct a RRSP contribution from your 2001 taxable income. In that case you would have to make the contribution before the 61st day in 2002.
What happens if I can’t contribute my full allowable amount?
If you can’t contribute the maximum in a year, you keep the right to put that money into your RRSP any time in the future.
For instance, say your earned income last year was $80,000. That would mean you could put in up to 18%, or $14,400. However, you would be capped at the dollar limit of $13,500.
Now suppose you only put $10,000 into your plan, leaving $3,500 of contribution room unused. In any future tax year, you can contribute that $3,500 to your RRSP in addition to your regular allowable contribution.
Can I take money out of my RRSP?
Yes. The money is yours to withdraw whenever you wish. However, when you take money out of your RRSP, it is included in your regular taxable income for that year. The money from your RRSP will be taxed at your marginal tax rate. This is true even if you’re withdrawing dividends or capital gains inside your plan, which normally would be taxed at a lower rate.
If you are buying a house with the RRSP money, the rules change. If you qualify, you can withdraw a maximum of $20,000 tax-free as a loan from your RRSP to buy a house. However, there are strict conditions you must follow:
1. If you withdraw your contribution within 90 days, you can’t deduct the contribution from your income.
2. You must repay all the money to your RRSP within 16 years.
3. You must start to repay the money the second year after you make the withdrawal.
4. The minimum annual repayment amount is 1/15 of the money you borrowed.
5. If you miss a payment, the payment amount is added to your taxable income for the year.
How old do I have to be to have a RRSP?
Anybody can have a RRSP as long as they have earned income. Even children who earn money, from a paper-route or working at a convenience store, should file a tax return. By making the government aware that you’ve earned an income, you earn the right to contribute to a RRSP. You can build up the contribution room and carry it forward over the years. So when you do start to make enough income to be taxed, you cut your tax bill by using your back contribution room. To learn more about back contribution room, click here.
How long can I have a RRSP for?
You have to close your RRSP by the end of the year in which you turn 69. To learn what to do with your RRSP when you turn 69, click here.