RRSP 101: What is an RRSP?

Key Takeaways

• The Registered Retirement Savings Plan (RRSP) is designed to assist you in saving for retirement by deferring taxes.
• Investing in RRSP is particularly beneficial when the marginal tax rate is significantly higher during the contribution year compared to the withdrawal year.
• The RRSP not only gives you tax advantages but also lowers your individual income. This can help you meet the income requirements for other government benefits.

As the RRSP season approaches, many individuals are faced with important decisions. They often encounter common questions such as:

• “Should I invest in RRSP?”
• “If so, how much should I invest?”
• “Is the Tax-Free Savings Account (TFSA) a better option than RRSP, or should one consider both?”
• “With stocks near recent highs, what if a market downturn occurs on March 2nd, and I’m fully invested?”
• “Conversely, if I keep all my assets in cash now, and the stock market not only avoids a downturn but experiences significant growth, what should I do?”
• “So, should I invest or not?”

According to a survey by CIBC, 51% of young individuals (aged 18-34) don’t have an RRSP account. Even close to retirement age (55 and above), 33% of Canadians haven’t opened an account. [1]

In my understanding, people don’t have an RRSP not because they don’t need it, but rather due to insufficient knowledge, misconceptions, and biases. To assist in optimizing the tax incentives provided by the government, I will explore this plan through a series of articles. Let’s begin by gaining an understanding of what an RRSP is.

What is an RRSP?

RRSP stands for Registered Retirement Savings Plan, a registered savings plan encouraging Canadians to save for retirement. RRSP comes with numerous benefits, with one of the most significant being the effective implementation of tax deferral. Tax deferral means that you can use RRSP contributions to claim tax deductions, and the investment growth within the RRSP account remains tax-free. However, when you withdraw funds from the RRSP account, the withdrawn amount is treated as income for the withdrawal year, subject to applicable taxes.

For example, let’s say you are a resident of Ontario and are taxed at the highest marginal rate of 53.53%. This means that for every additional dollar you earn, you have to pay $0.5353 in taxes. Feeling like the government is making more money than you, right? If you’re looking to reduce your tax burden, one of the simplest methods is by contributing to an RRSP. For example, if you contribute $1,000 to your RRSP, you won’t have to pay tax on that amount in the contribution year, effectively saving you $535.30 in taxes.

Certainly, there’s no free lunch. The taxes deferred during contributions must be repaid when withdrawals are made. However, for many individuals, as income tax rates tend to be higher during earning years than in retirement, strategically timing RRSP contributions and withdrawals can effectively lower overall tax payments. In the most ideal scenario, if the annual income, including RRSP withdrawals, is below the Basic Personal Amounts, the withdrawn funds might not need to be taxed at all. This represents the theoretical maximum amount of tax savings that an RRSP can provide for you

The amount of tax savings with an RRSP depends on individual tax rates during the contribution and withdrawal years. If the tax rate is higher during the contribution year compared to the withdrawal year, you can save more taxes through an RRSP account. However, if the tax rate during contribution equals that during withdrawal, contributing to an RRSP does not result in tax savings. In such cases, it is better to retain the RRSP contribution room and use it when future income is higher. Conversely, if the tax rate during contribution is lower than during withdrawal, contributing to an RRSP may increase your tax liability. In such situations, it is preferable not to purchase an RRSP.

For the Ontario 2023 income tax table, visit our RRSP Guide.

Figure 1: Comparison of an RRSP and a non-registered account

Please note that the above example only compares the advantages of RRSP from a tax rate perspective. Besides this, contributing to an RRSP comes with many other benefits. For instance, it can help reduce your income to meet the income requirements for other government benefits. Many Canadian benefits have income limits, and if your income exceeds the highest threshold, you won’t be eligible to apply for these benefits. In such cases, if you have sufficient funds and RRSP contribution room, contributing to an RRSP can lower your income, meeting the eligibility requirements for benefits. Therefore, contributing to an RRSP not only helps you save on taxes but also enables you to access more benefits.

When is the RRSP contribution deadline? 

You can contribute to an RRSP for the previous tax year within 60 days after the year-end. If this deadline falls on a weekend, it extends to the next business day. In 2024, being a leap year, the deadline is February 29, not March 1.

February 29, 2024 is the deadline for contributing to an RRSP for the 2023 tax year.

Tips: Contribute Early

Contributing to an RRSP sooner allows your investments more time to grow. As long as you have contribution room, you can purchase an RRSP at any time, not just during the RRSP season, gaining an additional year of investment growth compared to others.

Now, with a deeper understanding of RRSP, the next article will guide you on calculating available RRSP contribution room and how to open an account.

RRSP 102: Opening Your First RRSP account, Step-by-Step Guide

For more RRSP-related articles, please visit our RRSP Registered Retirement Savings Plan Guide.

Reference:
[1] https://www.newswire.ca/news-releases/are-rrsps-still-the-way-to-go-many-canadians-arent-sure-and-dont-seek-advice-cibc-poll-671047013.html

Last Updated: January 19, 2024
Published Date: January 20, 2019

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