What are RRSPs?
An RRSP (Registered Retirement Savings Plan) allows you to save and invest money for retirement. When you make a deposit to your RRSP this creates an income tax deduction that you can use in the current year or use on a future year’s income tax return. Tax deductions reduce your taxable income for the year and this often results in an income tax refund at tax time.
Any money in your RRSP grows tax-deferred. Any interest and/or dividends received are not taxed in the year they are earned. Similarly, any growth that is not from interest or dividends (capital gains) is also not taxed in the year it is realized.
The only time you pay tax related to an RRSP is when you make a withdrawal from the RRSP, except in certain circumstances. That tends to be missed or forgotten by a lot of people. Eventually you will have to pay tax on everything in your RRSP account(s).
Is an RRSP for you?
The biggest benefit of an RRSP is tax deferral, and to a lesser extent, tax avoidance. If your marginal tax rate (that is the tax rate that applies on the next dollar you earn) is the same when you withdraw the money as when you deposited it, you will have deferred the tax that was owing (as well as deferring tax on any gains).
If your marginal tax rate was very high when you deposited the money in the RRSP, say 40%, and lower when you withdraw it, say 30%, then you will have deferred as well as avoided some income tax.
The worst case occurs when your tax rate when you withdraw from your RRSP is higher than when you contributed. In that case, the tax rate you pay on the withdrawals could be higher than the tax deduction you got when you made the RRSP contribution. For more on this read: RRSPs. Should I have one?
Rule of Thumb
If you earn less than $50,000 a year and don’t expect this to increase much through future promotions or a career change, then an RRSP is probably not right for you. Instead, you should probably save for retirement in a TFSA. The only caveat to that is, if your employer offers RRSP matching, you should take full advantage of that matching and then anything else you want to save towards retirement should go into a TFSA.
Taking Money Out of RRSPs
When you take money out of an RRSP, you have to pay income tax on it, except under the Home Buyers Plan (HBP) and Lifelong Learning Plan (LLP). Why? The money that went into your RRSP essentially went in tax-free (it created a tax deduction), so when you take it out the government wants its piece.
The HBP and LLP are the only way to take money out of RRSPs and not pay tax on it. The catch is that the HBP and LLP are actually a loan from your RRSP; you actually have to pay back those amounts on a schedule set by Canada Revenue Agency. If you don’t make the repayments as they come due, they are added to you taxable income in that year and you pay tax on them, the same as any other withdrawal from an RRSP!
The HBP and LLP made sense in the pre-TFSA era, but make less sense now. From 1957 to 2009, an RRSP was the only way to save and invest your money and not pay tax on your income and gains. For short term goals like saving up for a home downpayment, school, or other things, a TFSA is better. And you don’t have to pay the money back to your TFSA.
When you buy your first home you usually end up buying a lot of stuff (furniture, paint, etc.). Are you going to have the money left over to make the HBP repayment, especially if the reason for buying the home was a new baby?
What happens to an RRSP when you retire?
When it comes to RRSPs, most people focus on the tax refund from making the contributions. But it is good to know what happens to your RRSP well before you retire.
When you retire, you have a few options, leave the RRSP as it is, convert it to a RRIF or use it to buy an annuity.
Leave the RRSP as it is
If you retire before the age of 71 (and I hope you do!) you can leave your RRSP as it is. If you have other savings you can use to live on, you can leave your RRSP as it is until age 71. This may be a good option for you if the RRSP is fairly small. If you want to make withdrwals from the RRSp to live on, CRA requires that the financial institution withhold income tax from it (like they require your employer to do with your paycheques). As well, most financial institutions charge an RRSP withdrawal fee (called deregistration) that usually ranges from $50 to $150 per withdrawal.
Convert to a RRIF
Anyone that has an RRSP at age 71 must convert their RRSP into a RRIF (Registered Retirement Income Fund). The rules around RRIFs require you to take a minimum amount out every year. Unlike RRSP withdrawals, there is no income tax withholding on the minimum withdrawals or withdrawal fees. Converting an RRSP to a RRIF early will help avoid the RRSP deregistration fees and income tax withholding, but locks you into a withdrawal schedule even if you don’t need the money.
Buy an annuity
An annuity is a product typically offered by insurance companies that provide regular payments in exchange for a lump sum upfront payment. Annuities come in many different forms, the details of which are better left for another post.
Combination of the three choices above
You can use part of an RRSP to buy an annuity at any time. You can also convert part of an RRSP to a RRIF. Once you get close to retirement you will have a better sense of what your income needs are and can decide what do with your RRSP.
Don’t get sucked into the RRSP marketing machine
Remember you don’t need to use an RRSP to save for retirement. A TFSA can be used to save for retirement, and can be a better choice for people making less than $50,000. While the refund generated by RRSP contributions can be irresistible, don’t forget that taking money out of an RRSP has tax consequences and RRSP are not meant for short-term savings.