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As the name suggests, a Registered Retirement Savings Plan (RRSP) is an account that helps Canadians save for retirement. It’s become a popular investment account over the years because any money inside of it grows on a tax-deferred basis, which means you only pay tax on your savings when you withdraw, likely later in life.
Understanding the RRSP
The RRSP was introduced in 1957 to help encourage Canadians to save for retirement by offering a few tax incentives. An RRSP is a type of registered account, which means it’s registered with the federal government to benefit from tax-deferred or tax-sheltered status. When you deposit money into an RRSP, you can claim that amount as a deduction on your income taxes. This reduces the amount of income tax you pay during what’s presumed to be your peak earning years: your 30s, 40s and 50s.
RRSP contribution money is only taxed when you withdraw it—ideally in retirement, when you’re earning less income (or no income) and your marginal tax rate is lower than your working years. RRSPs act as a tax shelter, and offer three main advantages:
- Tax deduction: When you contribute money to an RRSP, it can be claimed as a deduction when you file your annual income tax return. This reduces the amount of income tax you pay that year.
- Tax shelter: RRSP contributions grow tax-deferred as long as they remain in the account. This includes both interest and earnings made on RRSP investments, such as capital gains or dividends. Because you don’t have to pay tax annually and as a result of compound investing, your RRSP balance should grow significantly over several decades.
- Tax deferral: You’ll be taxed eventually, but think of it this way: contributing to an RRSP splits the tax burden between your present self and your future self, with the long-term goal of paying less tax overall.
Types of RRSPs
There are a few different types of RRSP accounts. They range from individual RRSPs, Spousal RRSPs, Group RRSPs and Polled Registered Pension Plan (PRPP):
Individual RRSP: An account registered in your name where all contributions, investments and earnings belong solely to you. Your RRSP can be inherited if you name a “qualified beneficiary,” which can be a spouse or common law partner, a financially dependent child or grandchild under age 18, or a financially dependent child or grandchild of any age who has a physical or mental disability. You can also leave your RRSP to a charity.
Spousal RRSP: An account registered in your spouse or common law partner’s name that you contribute to, or vice versa. You receive the tax deduction when you contribute to your spouse’s RRSP, and it also counts toward your annual contribution limit. However, when you remove the money later in life, it’s taxed in your spouse’s hands. This works well if your spouse will be in a lower tax bracket than you may be in when you retire.
Group RRSP: It’s similar to an individual RRSP, but it’s managed through your employer. Contributions are deducted automatically from your paycheque on a pre-tax basis, so you see the tax savings immediately. Your employer may also match or top up your contributions. Investment options for group RRSPs tend to be more limited, but many do offer a few options that staff may be able to choose from. Employers will usually cover the costs of administering and managing the plan, while you pay any investment costs.
Pooled registered pension plan (PRPP): A retirement savings account for people who are self-employed, or employees who don’t have a workplace pension plan. Because your assets are pooled with thousands of other individuals’ assets, it costs less to run the plan. If you’re a full-time employee of a federally regulated business or industry and your employer offers a PRPP, you will be automatically enrolled, though you can opt out. If you’re self-employed, you can enroll directly through a bank, insurance company or other licensed financial institution.
The magic of RRSP investing
RRSPs can hold almost all kinds of investments including stocks, bonds, guaranteed investment certificates (GICs), exchange traded funds (ETFs), mutual funds, index funds and cash. RRSP investments benefit from the power of compounding, which is when interest grows on top of already accumulated interest. The sooner you start saving, the longer your money has time to compound and grow. Don’t worry if you’re coming later to the saving and investing game–an RRSP can be opened at any time.
While the RRSP has many advantages, it’s not perfect. Here are some of the potential drawbacks to keep in mind.
Benefit clawbacks: When you turn 71, you’ll must close your RRSPs account and either take a lump sum cash payment or convert it into an income-producing annuity or registered retirement income fund (RRIF). If the money you withdraw from the account exceeds a certain amount, your old age security (OAS) and guaranteed income supplement (GIS) payments may be reduced.
You use it, you lose it: Save for a couple of cases, you permanently lose contribution room if you withdraw from your RRSP.
Contribution room is proportional to income: There is a limit to what you can contribute. The rules allow you to save 18% of your annual earned income, up to a maximum of $27,230 for the 2020 tax year.
Withdrawals are taxes as income: Withdrawals from an RRSP is taxed as earned income. This is important to note because in non-registered accounts, dividends and capital gains are taxed at lower-than-income rate. Anything held inside an RRSP, though, no matter what kind of investment, will be taxed based on your marginal rate when you withdraw.
How to set up an RRSP
There’s no minimum age or minimum balance for opening an RRSP. If you have a social insurance number (SIN) and file an income tax return, you can open an RRSP and start contributing. RRSPs can be opened at banks, credit unions, caisses populaires, trust companies, mutual fund companies, investment firms or insurance companies. If you’re ready to open an RRSP, here’s how to do it:
1. Select a type of RRSP
You can choose an individual, spousal or group RRSP, or the PRPP, based on your income and employment status, your marital status, and your investment goals. You can have more than one type of RRSP account, but annual contribution limits apply across all accounts. For example, you can contribute to both your individual RRSP account and your spouse’s RRSP account, but your personal annual contribution limit stays the same.
2. Decide how you want to invest
You can manage your own self-directed RRSP by setting up a trading account through a robo-advisor or discount brokerage, or get investment advice through a financial advisor. Each has different costs associated with trading, advising and managing your account. Here’s what you should know about each approach.
Automated approach: Robo-advisors offer a set-it-and-forget-it approach by asking you a few questions, assessing your risk profile and using algorithms to appropriately invest your money. You’re normally invested in a broad section of the market (passive/automated investing). Robo-advisors have low opening balance requirements and are inexpensive, with fees much lower than the cost of a financial advisor (0.4%-1% of your investments). Robo-advisors often require little human interaction, but many platforms provide some financial advice in the form of online tools or access to a financial advisor. They’re advantageous for hands-off investors who don’t want a DIY investment portfolio.
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DIY approach: A discount brokerage is much more hands on. You can pick your own stocks, bonds or funds that you want to invest in and, as the name suggests, trading fees are low (from between $0-$10 per trade depending on the institution). They can be a good fit for investors who want to trade frequently, though trading fees can add up. Discount brokerages don’t offer any financial advice.
Financial advisor approach: A financial advisor is someone who provides financial planning and can invest money on your behalf. The fees for a financial advisor are generally higher than a robo-advisor or a discount brokerage–often 1% to 2% of the assets they manage. Now that there are more low-cost options for investors, some financial advisors are only taking on higher net worth clients, often those with investable assets of $100,000 or above. Still, there are many advisors who will work with people across the income spectrum. They can be useful if you have a complicated financial situation, or if you need help budgeting.
Regardless of how you decide to start investing, the important part is to begin as soon as you can to take advantage of compounding. Over time the money you earn starts to make more money and it has a ripple affect. Once you’ve chosen an appropriate approach, the next is to choose the right investing service.
3. Choose a financial institution
RRSPs are widely available through major banks and credit unions/caisses populaires, so take your time comparing accounts, interest rates, withdrawal rules and investment options to find the best account for your needs.
4. Fund your account
Once your RRSP is open and ready to go, you can make your first contribution by transferring funds from an existing account, or by setting up automatic paycheque deductions through your employer.
RRSP contribution rules
RRSPs have annual contribution limits that change from year to year. The maximum contribution limit is the lesser of:
- 18% of your earned income from the previous tax year, or
- The annual maximum dollar limit set by the Canada Revenue Agency. For the 2020 tax year, the maximum is $27,230.
For example, if you earn $50,000 a year, you can contribute up to $9,000 annually to an RRSP. Any unused contribution room is carried forward to the next year. Make sure to track your contributions to report on your income tax return, but also because you’ll be penalized for over contributing. If you over-contribute by more than $2,000, you’ll be charged 1% on those excess contributions for each month that extra money sits in your RRSP.
The deadline for contributing to an RRSP for the previous tax year is usually March 1 or 2 of the current year. (So, any contributions made on Marc 1, 2021 will be for the 2020 tax year.) RRSP contributions can be made any time of year, but you’ll often hear the period between January and March referred to as “RRSP season” in an effort to rally people into last-minute contributions.
RRSP withdrawal rules
You can make withdrawals from your RRSP any time, as long as funds aren’t in a locked-in plan. When you withdraw funds from your RRSP, the money is subject to two types of taxes:
1. RRSP withdrawal tax: Also called a withholding tax, this tax only applies to early RRSP withdrawals. When you withdraw money from your RRSP before retirement, the bank holds back a portion of your withdrawal and sends it directly to the Canada Revenue Agency. Withholding tax is the same in every province and territory except Quebec. Here are the current RRSP withdrawal tax rates for all provinces except for Quebec:
- 10% on amounts up to $5,000
- 20% on amounts over $5,000 up to and including $15,000
- 30% on amounts over $15,000
In Quebec, early RRSP withdrawals are subject to both provincial and federal withholding taxes. Here are the current combined provincial and federal withdrawal taxes for Quebec:
- 20% on amounts up to $5,000
- 25% on amounts over $5,000 up to and including $15,000
- 30% on amounts over $15,000
2. Income tax: When you withdraw funds from your RRSP, you’ll have to claim that amount as income on your next tax return. RRSP withdrawals are taxed as earned income and the tax rate is dependent on how much money you earn. If you’re withdrawing a lot or if you’re still earning money from, say, a part time job, you could end up in a high tax bracket, which could result in a large tax hit. If you do withdraw early, and your marginal tax rate is higher than the withholding tax rate, you’ll have to pay additional tax on your withdrawals.
What happens when you withdraw early?
While you can technically withdraw money anytime, RRSPs are set up to encourage long-term savings and discourage taking out money before retirement. If you’re thinking about withdrawing money from your RRSP earlier than expected, there are a few financial consequences to consider.
You’ll pay taxes: If you withdraw from your RRSP at a time when you’re working and earning a healthy income, you may be increasing the amount of taxes you’ll pay.
You’ll lose out on tax-deferred compounding: Let’s say you withdraw $5,000 from your RRSP. Even if you replace that money later, you’ve lost out on valuable time to let your investment earn money and grow.
You’ll permanently lose the contribution room: When you withdraw money from an RRSP, you don’t get that contribution room back. So if you withdraw that $5,000 from your RRSP, your maximum lifetime contribution shrinks by $5,000. That means there’s less money in your RRSP to benefit from compounding interest.
How to withdraw from your RRSP without paying tax
You can search the darkest corners of the Internet for loopholes, but there’s no way to get out of paying taxes on RRSP withdrawals—you can only defer them. However, there are two government programs that let you withdraw from your RRSP without paying withholding or income taxes. However, they money must be repaid within certain timelines.
Home Buyers’ Plan: Allows you and/or your spouse to borrow up to $35,000 each from your RRSPs to finance a down payment to buy or build a home. A “first-time buyer” is defined as anyone who hasn’t occupied a home that they or their spouse/partner owned in the last five years. Whatever you borrow from your RRSP must be repaid within 15 years.
Lifelong Learning Plan: Allows you to withdraw up to $10,000 per year over four years from your RRSP (up to a maximum of $20,000) to pay for full-time education for you or your spouse/common law partner. The full amount had to be repaid to your RRSP within 10 years.
What happens to your RRSP when you turn 71?
You can’t hold onto an RRSP forever. When you turn 71, the government requires you to turn your retirement savings into retirement income.When it’s time to close your RRSP, you can pick one or more of the following options:
Take it in cash: You can take part or all of your RRSP savings as a lump sum. Of course, if you withdraw several decades worth of savings all at once, you’re going to pay a lot of tax.
Buy an annuity: An annuity is a type of insurance product that guarantees a fixed sum payment of money over a certain period of time or for the rest of your life. Just like withdrawals from an RRSP, annuity payments are taxed as income.
Convert it into a registered retirement income fund (RRIF): Transferring your money into an RRIF means it will continue to grow tax-deferred. However, the RRIF works a little differently. You’re required to withdraw a minimum amount of money from your RRIF annually, with the required minimum increasing incrementally every year.
RRIF vs. RRSP
Once your RRSP closes at age 71, the RRIF becomes another way to save for retirement. In many ways, it’s an extension of the RRSP: both are tax shelters for retirement savings. Like RRSPs, you can name a beneficiary to inherit your RRIF contributions after you die.
However, there are a few key differences. An RRSP is for saving and investing during your working life, while an RRIF is for withdrawing income during retirement. Once an RRIF is established, you can’t add more money to it. When the money is withdrawn, it’s subject to both a withholding tax and income tax.
TFSA vs. RRSP vs. RESP
Besides the RRSP, there are a couple of other tax-savvy accounts that can be used to save for retirement, your child’s post-secondary education, or other long-term savings goals.
Tax free savings account (TFSA)
The TFSA is a savings account where you contribute after-tax dollars. The biggest benefit of a TFSA is that because your contributions have already been taxed, you won’t be taxed again on any interest or investment gains, which means you can withdraw money truly tax-free. A TFSA can be used for short-term savings like an emergency fund, or for longer-term savings goals such as buying a house or retirement.
Like RRSPs, TFSAs have annual contribution limits ($6,000 a year for a TFSA) and can hold both cash and a variety of investments. But unlike the RRSP, any amount you withdraw from your TFSA is added back to your contribution room at the beginning of the following year.
Canadians must be at least 18 years old to open a TFSA, and the contribution room starts building the year you turn 18 (or in the year 2009, whichever is earlier), regardless of whether you earn an income.
When to use a TFSA vs. an RRSP
The two are often compared, but you don’t have to choose between one or the other—you can have one or the other, or both, or multiples of each to accomplish different savings goals. When it comes to saving for retirement, there’s a general rule of thumb: If you earn a lot of money now and expect to have a lower tax rate in retirement, consider an RRSP. If you have short-term investment goals or don’t earn a lot of money right now, but expect your salary will go up, consider a TFSA. TFSAs are also considered the better option for short-term goals because you can easily withdraw money without triggering taxes, and you get the contribution room back the following year.
Registered education savings plan (RESP)
An RESP is a savings plan specifically to help save for a child’s post-secondary education, up to a lifetime maximum of $50,000 per child. When your child is ready to attend university, they can withdraw the money to help pay for approved costs including tuition, housing, textbooks or living expenses. An RESP can stay open for up to 36 years, and can only be transferred to a sibling.
Anyone can contribute to an RESP, including grandparents, aunts and uncles, or friends or the family. There’s no tax deduction for contributing money to an RESP, but savings, interest and investment earnings grow tax-free as long as funds stay in the plan. The Canada Education Savings Grant program will also match annual contributions up to $500 per year, up to a lifetime maximum of $7,200 per child.
How RESP withdrawals are taxed depends on the type of withdrawals. Contribution withdrawals are called post-secondary educational expenses and aren’t taxed. RESP withdrawals that come from government grants and investment earnings are called educational assistance payments and are taxed as the student’s income.
Whether or not an RRSP is right for you depends on your income level, retirement plans and savings goals—all of which can evolve and change over time. But if you’re in your peak income-earning years and want to start putting away money you know you won’t touch for a long time, contributing to an RRSP can be a tax-efficient way to save for retirement.