Registered Retirement Savings Plan (RRSP)
The Registered Retirement Savings Plan (RRSP) is the most well-known and commonly used retirement account in Canada. Most working-age Canadians are aware of the potential income tax refund and tax-deferred growth that can be generated by making contributions to these accounts.
Each year you can make RRSP contributions up to your deduction limit and deduct these amounts from the taxable income reported on your income tax return. Understanding how your deduction limit is calculated is the starting point for your RRSP planning. In general, this is calculated as your unused deduction room at the end of the preceding year plus the lesser of: 18% of your earned income and the maximum deduction limit for the year ($27,830 as of 2021). Generally, earned income includes employment and self-employment earnings but does not include passive income such as dividends and interest. If you are a member of a pension plan at work, there may also be pension adjustments that are reported on your T4 which reduce your deduction limit. You can find your deduction limit on the Notice of Assessment that you receive each year after submitting your tax return.
Once you have determined how much you can contribute, you need to consider how much you should contribute. The primary benefits of the RRSP are that your contributions are deductible from taxable income and the income earned within the account is not taxable until withdrawal. In the year of withdrawal, the full amount, including original contributions and accumulated income, is subject to tax at your marginal tax rates. At a base level, RRSPs provide for a tax deferral, but this tax deferral can become tax savings with proper planning. A primary objective of RRSP planning is to claim deductions when you are in a higher tax bracket than you expect to be during the year that you withdraw them. Many individuals believe the best plan is to always maximize deductions today to lower their tax bill. In many situations, it may be advisable to preserve room for a future year when you expect to be in a significantly higher tax bracket.
Excess contributions of more than $2,000 above your deduction limit are subject to tax at a rate of 1% per month. You should withdraw excess contributions when you become aware of them. You may be able to leave the excess contributions in the account without penalty if sufficient room is created on January 1st of the subsequent year based on your earned income of the year of the excess contributions. If the excess amounts are not withdrawn in time, you may be required to submit a return reporting the excess amounts and pay the tax within 90 days after the calendar year. You can also request a waiver of this tax in certain circumstances, such as if the excess contributions arose due to a reasonable error. Beyond the tax considerations, you should also consider your personal financial goals when deciding how much to contribute. RRSPs are intended to be used for retirement and therefore are primarily geared towards long-term rather than short-term goals. If you withdraw funds from a RRSP prior to retirement, your withdrawal will be subject to income tax deductions at source based on the amount of the withdrawal and the amount must be reported as taxable income on your tax return. You may owe additional taxes at year-end depending on your marginal rate per your tax return. If you experienced income growth between the year of contribution and the year of withdrawal, then you will likely pay tax at a higher rate than you initially saved at. Other tax-advantaged accounts, such as the Tax-Free Savings Account, may be more beneficial for short-term savings goals.
There are two primary exceptions to the rules with respect to withdrawals: the Home Buyers’ Plan (HBP) and Lifelong Learning Plan (LLP). The HBP allows you to withdraw up to $35,000 without being subject to tax. Generally, you must be a first-time home buyer purchasing a qualifying home to be eligible for the HBP. You will be required to repay the amount withdrawn over a 15-year period beginning two years after the year of the withdrawal. Similarly, the LLP allows you to withdraw up to $10,000 without being subject to tax. Generally, you must be a full-time student enrolled in a qualifying program. Repayments are made over a 10-year period beginning in the second year after you cease to be a qualifying student.
RRSPs are flexible in terms of qualified investments. These include cash, Guaranteed Investment Certificates (GICs) and other deposits; securities including stocks, mutual funds, exchange-traded funds, or options; certain debt obligations; annuity contracts; and gold and silver. However, there are certain non-qualified and prohibited investments. These non-qualified and prohibited investments may be subject to tax at 50% of the fair market value of the asset.
You can continue to make RRSP contributions up until the year that you turn 71 years of age. At this time, you must either withdraw your funds, transfer them to a Registered Retirement Income Fund (RRIF) or purchase an annuity. A withdrawal of funds will be subject to tax and is only advisable in specific scenarios. Typically, the funds will be transferred to a RRIF or used to purchase an annuity. We can discuss these options further as you approach retirement or your 71st birthday.
RRSP contributions made in the first 60 days of each year can be deducted on your prior year income tax return. This allows you to properly plan on an annual basis and make contributions based on your current taxable income and expectations for the future.
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