RRSPs are one of the best options for Canadians looking to invest in their future. However, just like any other retirement savings plan, it’s vital to understand the RRSP pros and cons before deciding if it’s the right option for your financial situation.
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What is an RRSP?
A Registered Retirement Savings Plan, or RRSP, is a tax-advantaged account set up by the Canadian government to encourage people to save for retirement.
The main benefit of the RRSP is that it allows you to defer taxes until you withdraw your retirement savings from the RRSP. Any contributions to the plan don’t count towards your income for the year, allowing you to pay less tax now while investing in the future.
In addition to cash, you can also hold a wide range of other assets in your RRSP, including:
- Stocks traded on a major exchange
- Corporate and government bonds
- Mortgage-backed securities
- Gold and silver
- Mutual funds
- Exchange-traded funds
- Shares in Canadian small businesses, excluding your own private business or any business in which you own over 10% of the total share
- Guaranteed investment certificates
Any investments you make in the RRSP receive a tax exemption, as long as funds remain within the plan. This makes an RRSP an appealing investment tool that can help you maximize the gains from any investments you make.
Group vs. Individual RRSPs
A group RRSP, or GRRSP, is a company-administered RRSP. The company matches a portion or full amount of your annual RRSP contribution. Many employers offer group health and dental benefits, and a GRRSP is a welcome additional benefit.
GRRSPs have some limitations, namely limited investment options and higher fees, but the main benefit of a GRRSP easily overcomes these limitations. Employer-matching contributions mean that you can invest more money in a shorter amount of time.
Most employers deposit their GRRSP contribution directly into the plan. Not only does this stop you from spending the money on something else, but it also means that you gain the benefits of the investment right away.
Contribution Limits of an RRSP
Unfortunately, since RRSPs are registered plans, they limit annual contributions to reign in excess contributions. This limit is either 18% of the past year’s income or an annual amount set by the Canadian Revenue Agency (CRA), whichever is smaller.
The CRA evaluates its maximum limit annually, and you can find this year’s contribution limit on its website.
Receiving Income from an RRSP
An RRSP matures when the holder turns 71. In that year, you’ll have to decide whether you want to withdraw the funds, transfer them to a registered retirement income fund (RRIF), or purchase an annuity.
Any withdrawals from an RRSP count as income and are subject to income tax. If you’ve transferred your RRSP to an RRIF, you’ll have to pay income tax on the payments you receive from the RRIF, and the same applies to any annuities you purchased with your RRSP funds.
In general, the income tax varies depending on whether you withdraw the funds before or after you turn 71. You can expect to pay a much higher income tax rate on early withdrawals, as well as an additional withholding tax. If you withdraw your funds when the RRSP matures, you’ll still have to pay income tax, but at a lower rate.
Home Buyer’s and Lifelong Learning RRSP Plans
There are two major exceptions to the early withdrawal rules: if you use the funds to buy a house through the Home Buyer’s Plan or fund your education through the Lifelong Learner’s Plan.
The Home Buyer’s Plan lets you withdraw up to $35,000 tax-free to put towards a downpayment on a home. However, the Home Buyer’s Plan does have strict repayment rules that include repaying the withdrawal within 16 years and repaying 1/15th of the withdrawal annually.
The Lifelong Learning Plan is a similar program, where you can withdraw up to $10,000 tax-free in a year to pay for full-time education for you or your spouse. The repayment terms are also similar to the Home Buyer’s Plan in that you’ll have to pay the amount back within ten years and make 1/10th of the repayment each year.
In general, you can’t transfer your RRSP to another person as long as you’re alive. You can open a joint RRSP with a spouse or common-law partner but not with anyone else.
If you die, your RRSP funds will go to a chosen beneficiary on a tax-deferred basis. While the beneficiary will not pay income tax on receiving these funds, they will pay tax when withdrawing them.
RRSP Pros and Cons
Let’s examine the benefits and drawbacks of RRSP plans to help you make the best choice for your retirement planning.
Benefits of an RRSP
While most people use cash contributions to fund their RRSP, it’s possible to take advantage of the tax-free nature of the RRSP to maximize your investments. In most cases, you have to pay income tax on any investment or stock gain. However, if that growth happens in an RRSP, it’s tax-free as long as the funds remain in the plan.
By placing a portion of your investments into your RRSP, you can take advantage of any gains without losing out during tax season. And since one of the driving factors of a successful investment is compound growth, the more you save, the higher your eventual return.
RRSP Contributions Are Tax-Deductible
A major advantage of the RRSP is that any contributions you make towards the plan reduce your taxable income for the year. Paying less in taxes means you will have more money to invest, especially if you get a lump sum tax refund.
It’s important to note that you only defer paying taxes using your RRSP as you will eventually pay tax when you withdraw your funds. However, if used wisely, the tax deferment can allow you to increase your savings and set you up for a more comfortable retirement.
Limited Tax-Free Withdrawals
The main goal of the RRSP is to save money for retirement. However, you can still withdraw funds to put a down payment on a home or fund a full-time education through the Home Buyer’s Plan or Lifelong Learning Plan.
These withdrawals are the only time you won’t pay tax on an RRSP withdrawal, which is why both plans come with stringent repayment requirements.
Nobody ever expects to go bankrupt, but it’s still a factor to consider when planning your retirement. RRSPs are exempt from seizure during bankruptcy. This means that these funds are protected from creditors, and you won’t lose all of your savings if you find yourself in the unfortunate position of declaring bankruptcy.
However, there is an exception to this protection. The clawback rule states that any contributions made in the 12 months leading up to the bankruptcy aren’t exempt and can be seized by creditors.
The government designed RRSPs as retirement plans, which means that they have several rules to disincentivize early withdrawals. The plan also has other aspects that may make it less appealing in certain financial situations.
As with any other savings vehicle, understanding RRSP pros and cons can help you decide whether the plan’s benefits outweigh these drawbacks.
High Withholding Tax Rate
If you decide to withdraw from your RRSP before your retirement, you can expect to pay a heavy withholding rate. In most Canadian provinces, the tax owing on a withdrawal is:
- 10% on amounts below $5,000
- 20% on amounts between $5,000 and $15,000
- 30% on amounts over $15,000
Quebec has its own withholding rates. The withdrawal tax rate for Quebec is:
- 5% on amounts below $5,000
- 10% on amounts between $5,000 and $15,000
- 15% on amounts over $15,000
However, Quebec then charges an additional provincial withholding tax.
In addition to charging tax on the withdrawn amount, the amount is considered income and will be considered part of your taxable income for the year. So you’ll pay double taxes on each early withdrawal from your RRSP.
These measures are in place to disincentivize people from making withdrawals before the plan matures. While they may appear to be drawbacks, they offer the benefit of keeping your money in a dedicated savings plan.
Contribution Limit Based on Income
An RRSP has a contribution limit based on your annual income (or a set top-end limit). Plans with an income-based contribution limit tend to disadvantage lower-income earners who will have a much lower cap than the maximum contribution limit set by the CRA.
Since most investments benefit from compounding interest, lower-income earners tend to see significantly lower benefits than their higher-earning counterparts, especially over the plan’s lifetime.
RRSPs have a set date when they mature, affecting people who want to continue their RRSP after that date and those who want to retire early.
When you turn 71, you have to close your RRSP. Doing so stops you from taking advantage of the tax-deferment and investment benefits of the plan but allows you to take advantage of a favourable income tax rate from your RRIF.
However, suppose you want to retire before 71. In that case, you’ll have to either continue investing in your RRSP until you turn 71 or deal with the hefty penalties that come with early withdrawals.
RRSPs May Impact Federal Benefits
While RRSP contributions don’t affect federal benefits like Old Age Security (OAS) or Guaranteed Income Supplement (GIS), withdrawals from the RRSP can.
It’s important to remember that your RRSP withdrawal contributes to your annual income for tax purposes but also for federal benefits purposes. Once you hit a certain net taxable income, benefits like OAS are subject to a recovery, or clawback, tax.
The Difference Between a TFSA and RRSP
A popular alternative to the RRSP is the tax-free savings account or TFSA. The TFSA is similar to the RRSP in that contributions can include assets such as stocks and investments. TFSAs are life-long and don’t have early withdrawal penalties, whereas an RRSP expires when you turn 71 and has some hefty earthly withdrawal fees.
The main advantage of the RRSP is the tax-deferral. Since any RRSP contribution doesn’t contribute to your income tax for the year, it means that you can save money through your tax return. The TFSA doesn’t offer this tax-deferral functionality. Instead, it relies on granting tax-free growth throughout the life of the account.
A TFSA has a much lower contribution limit of $6,000 per year, but the plan does allow you to take advantage of missed years with additional contribution room. The RRSP, on the other hand, has a much higher annual contribution limit without the opportunity to make up for lost years.
TFSA vs. RRSP: Which Is Better?
Both TFSAs and RRSPs are excellent savings vehicles that everyone should consider. However, their function is different, and that’s reflected in how the two plans function.
In general, RRSPs are better for long-term retirement savings, where you can’t withdraw money without penalty and can contribute much higher amounts. In contrast, TFSAs are better for saving up for large expenses, like buying a house or car. They offer tax-free growth, and their lack of withdrawal penalties make it easier to simply withdraw the money when you need it.
Saving up for your retirement is essential, especially if you want an early retirement. For most people, RRSPs are the superior option — not only do they save money on your annual tax return, but they also have higher contribution limits that allow you to take advantage of any long-term investment strategies that will allow you to retire earlier.
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Is an RRSP The Right Move for You?
The Canadian government explicitly designed RRSPs to help people save up for retirement. As long as you keep their use in mind, they’re the ideal tool for the job.
In general, GRRSPs are the superior option since they allow employers to contribute as well. To help you find the ideal GRRSP provider, consider using a service like Group Enroll. We help employers find the ideal group RRSP and DPSP providers to suit their needs, considering the RRSP pros and cons for your business.
Simply request a quote using our online system. Our service team will get quotes from multiple providers, and we’ll help you choose the best proposal for your needs. You can also get in touch via email at [email protected] or visit our offices at 10 Great Gulf Drive, Unit 5, Vaughan, ON, L4K, 5W1. We look forward to helping you find the best GRRSP provider for your needs!