RRSPs provide advantages – but they’re not for everyone
By Tore Corrado, Advisor, Ciccone McKay Financial Group
Let’s look at the pros – and the cons – of Registered Retirement Savings Plans (RRSPs). Created in 1957, RRSPs allow Canadian investors aged 71 and younger to put money aside and let it grow, tax-deferred. When investors reach retirement, they can begin withdrawing from the account for income.
Like many Canadians, you may decide to incorporate an RRSP into your financial portfolio during your working years. Eventually you will have to close this account and open a new type: the Registered Retirement Income Fund (RRIF). Usually, you’ll do this around retirement age, but you do have up until the end of the calendar year you turn 71. Note that an RRIF has minimum withdrawals percentages per year; these increase over time, based on your age.
Key properties of an RRSP
Here are three key aspects to note when considering the appropriateness of an RRSP:
- Tax-deferred growth in the account – you don’t pay taxes on the investment growth.
- As an investor, you receive a tax deduction during your contribution years. This reduces your taxable income by your deposit amount, in the year you deposit.
- When it is time to withdraw from the plan, all money withdrawn from the RRSP will be taxed as income, in the year of the withdrawal.
- Your refund is based on your marginal tax bracket each year. The higher your taxable income, the more beneficial an RRSP deposit will be. If your income has increased recently, and you find a higher portion of your earnings directed to tax, an RRSP deposit may be more advantageous than ever.
- Individuals who do not have a pension or other savings plan in place through their employment will likely be required to fund their own retirement lifestyle. An RRSP can help establish an asset base. When employment income ceases, retirement withdrawals will fund lifestyle expenses. This is often especially significant for self-employed individuals.
- Individuals who will experience a one-off, substantial tax burden in one year could benefit from the ability to reduce taxes that year through an RRSP deposit. A common example of a one-year one-off is the disposition of a real estate asset, triggering a capital gain tax. RRSPs provide the opportunity to spread this tax over several years when withdrawals are made, reducing the overall taxes paid, and maximizing gains.
- In some households one spouse earns a higher income than the other. A spousal RRSP will allow for the contributing person to reduce their taxable income, and place the assets in their spouse’s name. Upon withdrawal the income will be taxable on the spouse, reducing the overall taxes paid by the household.
- Make lump-sum contributions to your plan before the RRSP deadline, to offset your previous year’s income.
- Make automatic contributions that align with your paycheque frequency (i.e., monthly, semi-monthly, or biweekly).
- You could also incorporate a hybrid model. Here you would make smaller, regular contributions, and before the deadline an additional lump-sum should your income be higher than expected.
Tax-deferred versus tax-free
This is the biggest misconception of RRSPs: Tax-deferred does not equal tax-free!
Tax-free means just that: You will not have to pay any taxes on the growth of your investment (with some exceptions), or on withdrawals. The Tax-Free Savings Account (TFSA) has given investors the benefit of tax-free investing since 2009.
On the other hand, tax-deferred status refers to investment earnings such asinterest, dividends or capital gainsthat accumulate tax-free until the investor withdraws these earnings. As mentioned before, the RRSP plan would be considered tax-deferred, meaning you will pay taxes on all withdrawals from your RRSP – just not yet.
Reducing your taxable income
The main benefit of an RRSP is that whatever amount you put into the plan, it will reduce your taxable income by an equivalent amount. For example, if your pre-tax income is $100,000 and you make an RRSP deposit of $10,000, you have reduced your taxable income to $90,000, providing an immediate tax saving.
Many people realize this gain in the form of a tax refund. See below for a strategic way to use that refund.
Taxes come due eventually
Essentially, the strategy behind an RRSP is to delay taxes to the retirement years. Tending to have less income, most retirees find themselves in a lower tax bracket.
A strategic way to use your tax savings is to invest them for your future retirement. By saving and investing your tax refund in an account like a TFSA, you will have multiple sources of income in retirement, some taxable and some possibly not. And you’re providing, for your future retired self, the highest form of net income.
Who should use an RRSP?
The RRSP is a powerful tool for Canadians in the capital-accumulation phase of their lives: their working years. But not everyone will benefit equally from this plan.
Using an RRSP, how do I save?
You’ve identified yourself as someone who could benefit from an RRSP. When it comes to saving via your RRSP account, you have two options.
This is a great strategy for those who don’t know how much they earn in a given year until the year ends. Such individuals might be self-employed, compensated by commission or else recipients of a bonus.
This is ideal for individuals who are paid a salary or hourly wage and can easily predict how much they will earn each year. In addition, it ensures they’re setting money aside each month for their retirement.
How much should I put into my RRSP?
Determining the amount of contributions to your RRSP each year is an art as much as a science. More than simply estimating the tax-savings you’ll have, first determine: what you are saving towards; your ability to save; and whether alternative approaches might lead to a more effective and efficient outcome.
An RRSP can be a substantial asset for you both during your working years and into your retirement. However, it is important to utilize this plan suitably within your own financial planning initiatives. A proper planning approach will shed light on how you can best save and invest for your future.
Tore Corrado is an advisor with Ciccone McKay Financial Group. Tore provides financial advice and direction, specializing in creating a collaborative approach to building and implementing long-term planning initiatives for his clients. If you want to learn more about how RRSPs can be incorporated into your financial portfolio, please feel free to contact Tore at salvatore@ciccone-mckay.com or 778-945-2651.
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