Episode #43: The Beginner’s Guide To RRSP’s
If you live and work and pay taxes in Canada then chances are you’ve probably heard the term RRSP. You’ve probably also wondered what exactly an RRSP is, looked it up, and then proceeded to be extremely confused by what it all means when you encountered dense articles with terms like tax deferral, contribution limits, and capital gains.
RRSP’s can seem a bit complicated and daunting to understand when you first start looking into them, and don’t worry you’re completely not alone in feeling that way. So, in today’s lesson I’m going to break down in layman's terms, the key points that you need to understand about having and using an RRSP, including:
What is an RRSP
How it affects your taxes
How to put money in
How to take money out
What is an RRSP?
The acronym RRSP stands for registered retirement savings plan. This is a type of investing account that is available to Canadians. What makes an RRSP different from other types of investing accounts, is that it’s a retirement investing account that comes along with a bunch of perks that are designed to encourage you to use this account by offering you financial rewards for doing so.
This is not too good to be true. The Canadian government wants its citizens to be financially secure in our old age and retirement years, so they created this specific type of account with its own rules and incentives to encourage you to use it for saving and investing for your future. There are two main financial benefits that come from using an RRSP, the first is that it’s a tax sheltered account, and the second is that it offers you a tax deferral.
What is a tax sheltered account?
When you put money into your RRSP account, the next step you want to take is to buy investments with the money in that account. Over time, as your investments grow you earn money, and the money you earn is called capital gains. Capital gains are a taxable form of income, this means that when you earn capital gains the government asks you to pay taxes on what you earn unless your investments are held in a tax sheltered account like an RRSP.
An RRSP is designed to be a long term investing account to save for your future, so this means that you can earn money in this account for say, 40 years, without ever having to pay tax on the money that you earn in there. This can save you truly huge sums of money over the course of your life, and help you retire with a much larger nest egg than if you use other taxable investment accounts.
So this is what tax sheltered means, it means that the money you earn is sheltered from paying tax back to the government, which is a huge incentive to use this type of account. Now that you understand what tax sheltered means and how it’s the first incentive to use this account, let’s look at the second incentive to use this account and what it means when I say that an RRSP offers you a tax deferral.
What is a tax deferral?
Contributing money to an RRSP gives you a tax deferral. This means you don’t pay tax on the money you contribute until you take it out in your retirement. The graphic below explains exactly how this tax deferral works.
All of this means that by contributing $18,000.00 to your RRSP, you pay $6,160.00 less tax, so your after tax income is $6,160.00 higher.
Remember, this account is designed for long term saving and investing for your future and retirement. You’re not supposed to start taking money out of this account until you’re ‘retired’. When you take money out of this account in the future, it will be taxable. This is why it’s called a tax deferral, BUT the overall idea is that you’re going to be in a lower tax bracket in your retirement than you are during the earning years of your life. For example you’ll be in a $70,000.00 tax bracket in the future, instead of the $100,000 tax bracket you’re in right now. This means you’ll pay less tax on that money if you take it out in the future than you would if you just kept it in your pocket now AND you’ll have had the benefit of your money and investments growing without being taxed on capital gains for all those years.
How the RRSP tax deferral benefits you if you’re employed vs self employed
Now this is where RRSP’s differ slightly if you’re traditionally employed vs being self employed. If you’re traditionally employed, then you’re likely paying tax with every paycheck. This means that if you’re also contributing to your RRSP, you’ll likely overpay your taxes over the course of the year, which means the government will send you back the portion of your taxes that you’ve saved by contributing to your RRSP.
If you’re self employed that means you’re responsible throughout the year to save and pay your own taxes, so when you file your taxes at the end of the year they’re just going to ask that you pay less tax. So instead of getting back tax that you’ve overpaid, you just don’t pay that extra tax in the first place. Both scenarios end up in the same place with you saving the same amount of money on your taxes and having more money left in your pockets.
How much money can you contribute to your RRSP?
Your RRSP account has what’s called a contribution limit. This means you can’t just put all your money into the account to shelter yourself from taxes. There is a limit to how much you can put in each year, and there’s a penalty for over contributing, so you want to make sure you don’t put too much in.
The amount that you’re allowed to contribute to your RRSP is the lesser of 18% of your previous years’ salary or the maximum contribution limit for the year. This means that if your salary last year was $100,000.00 you’re allowed to contribute $18,000.00. The maximum contribution limit is designed to cap extremely high income earners, the amount changes a bit each year, this year for 2021 it’s $27,830.00.
If you’re not sure how much you’re allowed to contribute you can find that number on your CRA my account page, or you can find your contribution limit on the NOA, notice of assessment, that you received after you filed your taxes last year.
Another note on contribution limits is that your available space rolls over from previous years. This means if you’ve been working and filing taxes in Canada for a few years but haven’t contributed to your RRSP yet, then all of the contribution space you didn’t use in previous years is still available to you, so you might have a very hefty amount of room left in your RRSP.
The other point to note about your contribution limit, is that it’s based on your deposits into the account, not your account growth. This means if your investments within your account have grown to be greater than your contribution limit that doesn’t matter, you can still contribute the allowable amount because it’s purely based on how much you’ve deposited into the account, not how much exists in the account now that your investments are performing well.
How to contribute money to your RRSP
First things first, you have to open up an RRSP account. This is very easy to do, and involves minimal paperwork. There are so many places that you can open an RRSP, it’s really up to you to decide what you need from the provider. For example you could open one with a big name bank with physical branches like RBC, an online only bank like EQ bank, or an online brokerage like wealthsimple.
Once you have an RRSP account you need to contribute money to that account. If you’re traditionally employed then your employer probably offers you the option of contributing to your RRSP for you. This means that with every paycheck a portion is taken off and contributed to your RRSP automatically. Some employers even offer an RRSP match program which means they match your contribution to a certain percentage if you use the program which is a really awesome way of saying yes to some of the other free money that’s on the table. You could also contribute to your RRSP manually every time you get paid if you have a steady paycheck, or as a lump sum once a year if your income is sporadic for example you’re self employed.
No matter what way you choose to contribute money to your RRSP there’s one important point to note and that’s that there is a contribution deadline you need to meet in order to take advantage of the tax deferral. That deadline is March 1st. So if we’re talking about your RRSP contributions and taxes for 2021, you want to make sure that you’ve finished contributing to your RRSP by March 1st 2022 at the latest, in order to claim the tax deferral on your taxes for 2021.
Taking money out of your RRSP
As I’ve said a few times already, the RRSP is an investment account designed for long term saving and investing for your retirement. This means it has incentives to get you to save for your retirement, and disincentives for taking money out too early.
If you take money out of your RRSP you lose that contribution room. If you do this too early you’re strongly impacting your account’s ability to grow through investments into a large retirement nest egg. If you think you’re going to need the money in the next few years then it’s not a good idea to invest it into an RRSP, an account like a TFSA is a much better choice.
There are two exceptions that will allow you to take money out of your RRSP. The first is called the first time home buyers plan, and the second is called the life long learning plan.
The first time home buyers plan is designed to help people have access to the necessary cash for the down payment on their first home, and the learning plan is designed to help pay for adult schooling costs for you or your partner. There are different requirements for each plan that change slightly over time so I recommend just looking them up if you want to use one of these programs, but the overall point to understand is that these programs let you take a certain amount of money out of your RRSP without penalty provided you pay the full amount back within a set amount of years. It’s like taking a loan for yourself. If you miss the repayment date then you incur penalties on the money you took out of your RRSP.
Now I don’t want to end the episode all doom and gloom talking about penalties for not using your RRSP correctly because really there are just a few very simple rules to follow to avoid penalties, and the upside of having an using an RRSP over the course of your working life is huge. So, let’s just remember the perks:
Perk #1 by contributing money to an RRSP you will lower your taxable income for the year and therefore pay less tax. This means you’ll either get money back from the government for having overpaid your taxes, or you’ll simply pay less tax at the end of the year.
Perk #2 the money you contribute to your RRSP should be used to buy investments. These investments can grow in your RRSP over the years, without having to pay any additional tax on the money you’re making from them.
Perk #3 If your employer offers an RRSP contribution match then hallelujah sign yourself up for that shit right now. That’s literally free money that your employer is offering you for being a financially savvy and responsable employee, use that.
Perk #4 even though you don’t want to take money out of your RRSP too early, the government recognizes that there are major life events that do require more cash like buying a home or going back to school, so they’ve set a couple loopholes into the RRSP that will allow you to access that money if you really need to.
Hopefully you’re feeling more confident and inspired to open your own RRSP and start contributing to it, as always if you have any questions please feel free to drop them in the comments or message me directly on instagram.
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