Episode #44: How To Use Your RRSP Account To Pay Less Tax
If you live and work in Canada, then chances are you pay taxes in Canada. And even though you know your taxes go towards providing you with things like roads, and healthcare, which you’re grateful for, chances are you’re not the biggest fan of paying taxes. If you could pay less tax then you would. So, what if I told you that there’s an entirely legal way to pay less tax, and that our Canadian government actually wants you to do this? Sound clickbait-y? Sound too good to be true? Well, this is one of the few things in life that is not in fact too good to be true. The way that you do this is by saving some of your money in a special account called an RRSP, and for today’s personal finance lesson I’m going to talk about what exactly an RRSP is, and the two ways that it can save you money in taxes.
How an RRSP works
Last week I also posted a video all about RRSPs, and that one was a beginners guide to using your RRSP. If all this is new to you then I recommend checking out that episode first to learn an overview of what an RRSP is and how to use one, and then watch this video for the specifics about how you can use your RRSP to save money on your taxes.
To give you a brief overview though, the term RRSP stands for registered retirement savings plan. An RRSP is a special type of Canadian savings account that's designed to be used to save and invest for long term goals such as your retirement. This is not the right type of account to use if you’re saving money you know you’ll need to access in the next couple of years, it’s specifically designed to be for retirement savings.
And the way that you use an RRSP is you contribute some of your savings money to this account every year, and then you buy investments within that RRSP account. Sometimes people are confused thinking that the RRSP is the investment, don’t make that mistake, the RRSP is the account you put money into and you can then buy investment products like Index funds, mutual funds, stocks, within that account.
If you’re traditionally employed then your employer might offer a program where they contribute some of your paycheck to your RRSP automatically as a form of enforced savings if you want to join a program like that. AND some employers even offer an RRSP match, meaning they match a certain percentage of the money that you put into your RRSP, and that’s money from your employer that you otherwise would not get. So, check if your employer offers an RRSP match program and sign up for that shit because if you’re not doing that then you’re literally leaving upwards of thousands of dollars a year of free money on the table.
So, that’s a quick, very brief overview of what an RRSP is, again if you want more detail (which I recommend) then make sure you catch last week’s episode. Now I know you’re dying for me to get to the good stuff which is specifically how you can use an RRSP to save a pretty significant amount of money on your taxes. And the truth is there are actually two ways that RRSPs can save you money, and I’m going to walk you through both now.
How an RRSP Saves You Money on Taxes
An RRSP is what’s known as a ‘tax sheltered account’ and it also offers you what’s called a ‘tax deferral’ which is what I talked about at the start of this video. By using an RRSP you get both of these benefits, which is freaking huge when it comes to saving you so much money over the course of your life. The tax deferral results in more immediate savings, the tax sheltered part results in more long term savings, both are key.
Let’s start with the part about an RRSP being a tax sheltered account. This is a very literal term, it means that the money you make in your RRSP is literally sheltered from government taxes each year, and here’s how this works.
RRSPs are Tax Sheltered Accounts
When you put money into your RRSP, you then use it to buy investments. You want to buy investments as opposed to just letting your money sit there, otherwise you’re missing out on the biggest superpower that the RRSP has to offer you.
When you buy and hold investments in this account, over time your investments will grow and earn you money. The money you earn from these investments is known as capital gains in the finance world. Don’t be thrown off by the finance jargon, capital gains here just means the money you earned from your investments. Now, generally speaking, any type of earned money is income, meaning you pay income tax on it. In the case of capital gains earnings, you pay what’s called capital gains tax on it, which is calculated differently than income tax but the end result is the same that you have to pay the government a portion of your earnings in the form of taxes. BUT, your RRSP account is a tax sheltered account, this means that you don’t pay tax on the money that your investments earn in there, you don’t have to pay capital gains tax because your money is in this account. And this is a perk that allows your money to grow very rapidly in your RRSP without the government every year saying ‘oh actually I’ll take part of what you earned thank you very much.’ As you can probably imagine, this means that you’re going to retire with drastically more money in this RRSP account, than you would if you used an investment account that’s not tax sheltered.
This is the primary way that using an RRSP will save you tons of money over the course of your life. Seeing as how you’re not planning on accessing this money until you’re retired though you probably won’t feel the effects of this perk right away, which brings us to the second tax saving perk that will save you money right away, which is the fact that RRSP’s offer you what’s called a tax deferral.
RRSPs Offer a Tax Deferral
This means that you don’t pay income tax on the money that you contribute to your RRSP that year, instead you defer the tax payment to when you take the money back out of your RRSP in the form of income. This saves you money today and leaves you with more money in your pockets right away, and it will probably save you tax money as a net calculation when you take it back out again because theoretically you’ll be in a lower tax bracket when you’re retired meaning you pay a lower percentage of tax dollar for dollar than you do right now.
This is a transcription of a video example. I recommend watching the video here to visually see the tax calculator work.
So, here you’ll see I’ve pulled up a free online income tax calculator. This is one from Turbo tax, you can find it easily if you google search ‘income tax calculator’. And we’re just going to put in that we’re in Ontario because that’s where I’m located. Now let’s fill out this form here, and we’re just going through a very simple version of this. Let’s say you make $100,000.00 a year, that means you’re going to pay roughly $23,028.00 in tax. If you look down below the big red number here you’ll see the federal tax amount, the provincial tax amount, and the big red tax number up above does not include your CPP contributions, that CPP number will not change as we go through the rest of this.
Now you’ve got your income of $100,000.00, and this time you contribute $18,000.00 to your RRSP. This time when we run the calculator, you can see that the amount of tax you have to pay drops down to $16,868.00. That’s $6,160.00 less.
And the reason that this happens is because when you file your taxes, your RRSP contribution has the effect of lowering your taxable income, it makes it so that on paper you’ve earned less money therefore you have to pay less tax. Let me show you. So we said your income is $100,000.00, you contribute $18,000.00 to your RRSP. This lowers your taxable income to $82,000.00, that’s $100,000 - $18,000. So this time let’s put your income into the calculator as $82,000.00, run the calculator, and your taxes remain at $16,868.00.
It’s as if the government says okay, we see that you put $18,000.00 into your RRSP, which we want you to do, and we recognize that this means you won’t have that $18,000.00 available this year to live on now, so we’re going to recognize your income as only $82,000.00, so you pay less tax, and it becomes easier to save that $18,000.00.
So, by contributing to your RRSP you’ve saved yourself $6,160.00 dollars that you otherwise would have paid to the government in taxes, and from here this can work one of two ways. If you’re traditionally employed, then chances are your taxes have been deducted from your paycheck for the whole year. Then, when you contribute to your RRSP and file your taxes, it becomes clear that over the course of the year you’ve paid the government too much tax, so they send you back that $6,160.00 that you’ve overpaid. Depending on how you’re set up with the CRA they’ll either send you a cheque, or direct deposit that money back into your bank account, which is awesome. Everybody likes to have extra money deposited into their bank accounts. If you’re self employed and you only pay your taxes once annually, then your RRSP deduction will be taken into account when you file your taxes, and the government will ask you to pay whatever tax you owe minus that $6,160.00, so you just pay less tax. Either way no matter how you’re employed, it results in you having more money left in your pocket after the tax man comes knocking.
The Rules of Using an RRSP
Now a quick note on how you can use your RRSP properly, because there are some rules around using an RRSP that are designed to keep people from just putting tonnes and tonnes of money in there and never paying any tax ever. So, don’t skip this part because you don’t want to do it wrong. We need to quickly cover how much money you’re allowed to put into your RRSP, the penalty for over contributing, and the deadline you need to honor to make sure you actually get to claim this tax deferral and get your tax refund.
How Much Money Can You Contribute To Your RRSP?
There is a limit to how much money you are allowed to put into your RRSP, and that limit varies with your income level. Luckily it’s super easy to find out how much money you personally are allowed to contribute. And the way that it works is you’re allowed to contribute the lesser of, either 18% of your previous years income, or the maximum contribution limit of $27,830.00. The maximum limit changes a bit each year, for 2021 it’s $27,830.00. So, let’s say you earned $100,000.00 last year. That means that this year you’re allowed to contribute 18% of that, which is $18,000.00, as we were using in the example. Say this year your salary increases to $150,000.00, that means that next year you’re allowed to contribute 18% of that, which is $27,000.00. Then say your income increases to $300,000.00, but 18% of that is now higher than the maximum contribution limit, so instead you’re allowed to contribute the maximum contribution limit for that year, let’s say it’s the same as this year, so that’s $27,830.00
If you haven’t been contributing to your RRSP yet but you’ve been working and filing taxes for a few years, then the contribution room from previous years that you haven’t used continue to roll over, that means it continues to add up, so you’ll probably have a pretty hefty amount of room available in your RRSP to contribute money to.
If you have no idea how much room you have, fear not that is very easy information for you to find, and you can find it in one of two ways. First, you can always log into your CRA my account webpage, where you will find your RRSP contribution limit clearly listed in your account. Second you can look at the Notice of Assessment form you received after you filed your taxes last year, and that also has your RRSP contribution room clearly listed on that form.
It’s important to know what your limit is, because you don’t want to overcontribute. There is a financial penalty for over contributing to your RRSP. They don’t want you to do that, so they will charge you 1% every month that the extra contributions are in your account. They even give you a little wiggle room of $2,000.00 a year so you don’t accidentally mess this up. You won’t do that though because now you know exactly where to check your contribution room. Right? Right.
What is the RRSP Contribution Deadline?
And last but not least, the final thing you need to know about how to contribute to your RRSP to save on your taxes this year is that you must heed the contribution deadline. The contribution deadline is March 1st, this means you want to have all of the money you want to contribute to your RRSP for last year, in the account by the end of February this year. That way, when you file your taxes, you’ve already put away all the money you need to into your RRSP account to get your tax refund on the taxes you’ve paid over the course of the last year. So, it is currently the beginning of 2022, tax time is approaching where we will be filing our taxes for the 2021 year, if you want to claim the RRSP deduction on your taxes to get your refund for the past year you have to have finished your entire contribution before the March 1st cutoff date this year.
And those are the main points of what you need to know if you want to start using an RRSP account to both save for your retirement, AND to save on your taxes this year. Let’s do a quick recap of the most important points to know to do this properly.
You’re allowed to contribute either 18% of last years’ salary OR the maximum contribution limit, whatever the lesser amount is for you.
You need to have finished your contributions for the year by March 1st this year in order to claim the RRSP contribution on your taxes for the past year.
When you contribute money to your RRSP you have the option to claim that contribution on your taxes in order to lower your taxable income. This means that you’re going to pay less tax for your salary than you would if you didn’t contribute.
You will receive that money either in the form of a ‘refund’ from the government, or you will simply have to pay less tax depending on how you’re employed.
The money that you contribute to your RRSP is meant to not be touched for a very long time in order to fund your retirement. This means you want to buy investments within that RRSP account. As these investments grow and earn you money, they will be sheltered from capital gains tax, meaning you won’t have to pay taxes for that growth.
When you eventually take money out of that account when you’re retired, you will have to pay income tax on it, but it’s assumed you will be in a lower tax bracket at that point in your life, which means you’ll pay less tax on the money than you would if you just kept it right now, meaning you’ll come out net positive and save money in the long run, in addition to keeping more money in your pocket today.
And that’s it for using RRSPs to save money on your taxes. There are a number of different things to understand about your RRSP that I didn’t cover in today’s video, this video was quite specific about using your RRSP to lower your tax burden, so if you don’t really know anything about RRSPs, again I recommend checking out last week’s lesson for a general overview of these accounts for beginners. Also, you’ll often see RRSPs compared with TFSAs which is another type of tax sheltered account, that is similar but has some different rules because it’s meant to be used in a different way. If you also need to learn about TFSAs make sure you hit subscribe on the channel and leave me a comment if you have any specific questions because I will be releasing a lesson all about TFSAs as well as comparing the two accounts in the near future, so you don’t want to miss that.
Linked Resources
Want to learn the first steps you should take you start managing your money? Take the quick quiz on the How To Adult School home page!
Want to learn more about managing your finances like an adult? Sign up for the free back to basics beginner finance course.
Instagram: How To Adult School on Instagram
Tiktok: How To Adult School on Tiktok
Youtube: How To Adult Show on Youtube
Podcast: How To Adult Show Podcast
NOTE: This page contains affiliate links that allow you to find the items mentioned in this episode and support the show at no cost to you. While this show may earn minimal sums when the viewer uses the links, the viewer is in NO WAY obligated to use these links. Thank you for your support!