A Registered Retirement Savings Plan or RRSP is an account that provides tax benefits for saving for retirement in Canada. RRSP refers to a provision in the Income Tax Act that allows a person to shelter financial property from income taxes.
RRSPs may reduce taxes in up to three ways:
- Contributions to RRSPs, up to limits described below, may be deducted from income before calculating income tax due.
- Income earned within the account (interest, corporate dividends, trust distributions, capital gains) is not taxed until money is withdrawn from the plan, allowing the plan to grow faster than the same investments would grow if they were held outside the plan and thus subject to tax.
- Money may be withdrawn from an RRSP in tax years when one is in a lower income-tax bracket because of lower income (due to retirement, unemployment, etc.) than tax years when one makes contributions.
Examples of financial property that can be held in an RRSP are: savings accounts, guaranteed investment certificates (GICs), bonds, mortgage loans, mutual funds, income trusts, corporate shares (stocks), and labour-sponsored funds.
Registered retirement savings plans provide a form of deferred taxation to individuals. For the most part, contributions to RRSPs are deductible from taxable income, reducing income tax payable. Since Canada has a progressive tax system, taxes are reduced at the highest marginal rate. Increases in the value of the plan assets (whether capital gains, interest income or other) are not subject to income or other taxes in Canada until funds are removed from the RRSP.
Disbursements from an RRSP are taxable as income at the time of withdrawal. Since an RRSP is intended for retirement (when many taxpayers will have lower taxable income), the tax paid may be lower, although this will also depend on the increase in the value of the plan assets, or investment returns, and other factors. All disbursements from the RRSP are taxed at the same rate regardless the type of income. This implies capital gains will lose their 50% exemption, and dividends will lose their dividend tax credit. Thus, interest income becomes much more attractive as an RRSP instrument.
Since RRSPs allow many taxpayers to substantially defer (delay) or reduce income taxes payable, there are limits established on maximum allowable contributions, timing of certain contributions, and many other details. RRSPs are intended to allow individual taxpayers to save funds for retirement, and hence minimum disbursement (withdrawal) levels are established above a certain age.
Types of RRSPs
RRSP accounts can be setup with either one or two associated individuals:
An Individual RRSP is associated with only a single individual, termed an account holder. With Individual RRSPs, the account holder is also called a contributor, as only they contribute money to their RRSP.
A Spousal RRSP allows a higher earner, termed a spousal contributor, to contribute to an RRSP in the spouse’s name. In this case, it is the spouse who is the account holder. The spouse can withdraw the funds, subject to tax, after a holding period. A spousal RRSP is a means of splitting income in retirement: By dividing investment properties between both spouses each spouse will receive half the income, and thus the marginal tax rate will be lower than if one spouse earned all of the income.
In a group RRSP, an employer arranges for employees to make contributions, as they wish, through a schedule of regular payroll deductions. The employee can decide the size of contribution per year and the employer will deduct an amount accordingly and submit it to the investment manager selected to administer the group account. The contribution is then deposited into the employee’s individual account and invested as specified. The primary difference with a group plan is that the contributor realizes the tax savings immediately, instead of having to wait until the end of the tax year.
Both Individual and Spousal RRSPs can be held in one of three account structures. It should be noted that one or more of the account types below may not be an option depending on what type of investment instrument (example stocks, mutual funds, bonds) is being held inside the RRSP.
All three of the accounts below must normally be opened up by an individual through an investment advisor. That is to say, individuals interested in opening up accounts without an advisor usually find themselves unable to do so.
Client-held, or client-name accounts, exist when an account holder uses their RRSP contributions to purchase an investment with a particular investment company. Each time an individual uses RRSP contribution money to purchase an investment at a different fund company, it results in a separate client-held account being opened. For example, if an individual buys investment # 1 with Fidelity Investments and investment # 2 with Mackenzie Financial, this would result in the individual having two separate RRSP accounts held with two different companies.
The main benefit of client-held accounts is that they do not generally incur annual fees. The main detriment is that investors must keep track of each RRSP investment made with each separate company.
Nominee accounts are so named because individuals with this type of account nominate a nominee, usually one of Canada’s five major banks or a major investment dealer, to hold a number of different investments in a single account. For example, if an individual buys investment # 1 with Fidelity Investments and investment #2 with Mackenzie Financial, both investments are held in a single RRSP account with the nominee.
The main benefit of a nominee account is the ability to keep track of all RRSP investments within a single account. The main detriment is that nominee accounts often incur annual fees.
A “self-directed” RRSP (SDRSP) is special kind of nominee account. It is essentially a trading account at a brokerage that has tax-sheltered status. The holder of a self-directed RRSP instructs the brokerage to buy and sell securities on their behalf as with any brokerage account. The reason that it’s described as “self-directed” is that the holder of this kind of RRSP directs all the investment decisions themselves, and does not normally have the service of an investment advisor.
Intermediary accounts are essentially identical in function to Nominee accounts. The reason an investor would have an Intermediary account instead of a Nominee account has to do with the investment advisor they deal with. If the advisor is not aligned with a major bank or investment dealer, they may not have the logistical ability to offer nominee accounts to their clients.
As a result, the advisor will approach an intermediary company which is able to offer the investor identical benefits as those offered by a nominee account. The three main Canadian companies who offer intermediary services are B2B Trust, M.R.S. Trust, and Canadian Western Trust (CWT).
The main benefits and detriments of Intermediary accounts are identical as those offered by Nominee accounts.
A RRSP deduction limit is the maximum amount of RRSP contributions that can be claimed on a tax return for a given tax year.
A deduction limit is generally calculated as 18% of a person’s earned income from the previous tax year, minus any “pension adjustment”, up to a specified maximum. This specified maximum has been rising as shown in the table.
After 2010 the RRSP contribution limit will be indexed to the annual increase in the average wage. Any RRSP deductions not taken in a tax year are carried forward indefinitely to future tax years. So, for example, if a person’s RRSP deduction limit is $8,000 and he deducts only $3,000, the unused $5,000 deduction is carried forward. Furthermore, it would be increased by the deduction limit as calculated by the formula above.
One of the major advantages of RRSPs in Canada is that they are tax deductible. This means that the amount of money put into an RRSP will be deducted from one’s income. It is deducted based on the marginal tax bracket, or the amount of tax paid on the last dollar of earned income. For a person with a marginal tax bracket of 40%, this could mean that in an investment of $1000 in an RRSP, they would receive $400 back in taxes. Furthermore, an RRSP’s tax deduction also carries forward; for example, a student with their eyes on a doctorate in a lower tax bracket could contribute to their RRSP for the term of their schooling and not deduct the taxes. When they graduate and become employed as a practicing professional, they could use their RRSP deductions to deduct their RRSP contributions from the previous years at their current marginal tax rate.
A RRSP can be contributed to until the annuitant is aged 71, when it must be either cashed out or matured into a RRIF.
While it is possible to contribute more than the contributor’s deduction limit, it is generally not advised as the excess amount (presently $2,000 over the deduction limit) is subject to a significant penalty tax removing all benefits (1% per month on the overage amount).
RRSP contributions within the first 60 days of the tax year (which may or may not be the calendar year) must be reported on the previous year’s return, according to the Income Tax Act. Such contributions may also be used as deduction for the previous tax year. Note that reporting and using are two different things. All other contributions may be used in the same tax year or held for future use.
- For a complete article on Registered Retirement Income Funds (RRIF), see Registered Retirement Income Fund.
An account holder is able to cash out an amount from an RRSP at any age. However, any amount withdrawn qualifies as taxable income and is therefore subject to withholding tax.
Before the end of the year the account holder turns 71, the RRSP must either be cashed out or transferred to a Registered Retirement Income Fund (RRIF) or an annuity. Previous to 2007, account holders were required to make this decision at age 69 rather than 71.
Investments held in an RRIF can continue to grow tax-free indefinitely, though an obligatory minimum RRIF withdrawal amount is cashed out and sent to the account holder each year. At that time, an individual’s income is expected to be lower and therefore subjected to less tax.
Special withdrawal programs
Home Buyer’s Plan (HBP)
While the original purpose of RRSPs was to help Canadians save for retirement, it is possible to use RRSP funds to help purchase one’s first home under what is known as the Home Buyer’s Plan. Canadians can borrow, tax-free, up to $20,000 from their RRSP (and another $20,000 from a spousal RRSP) towards buying their residence. This loan has to be repaid within 15 years after two years of grace. Contrary to popular belief, this plan can be used more than once per lifetime, as long as the borrower did not own a residence in the previous five years, and has fully repaid any previous loans under this plan.
Lifelong Learning Plan (LLP)
Similarly to the Home Buyer’s Plan, the Life-Long Learning Plan allows for temporary diversions of tax-free funds from an RRSP. This program allows individuals to borrow from an RRSP to go or return to post-secondary school. The user may withdraw up to $10,000 per year to a maximum of $20,000. The first repayment under the LLP will be due at the earliest of the following 2 dates:
1. 60 days after the 5th year following the 1st withdrawal
2. The 2nd year after the last year the student was enrolled in full-time studies