The Low Down on Registered Plans: The Benefits of RRSPs
If you’re a Canadian resident over the age of 18, you’re probably familiar with RRSPs and understand that they are an important component of retirement planning. Yet, you may not realize the many ways you can use your RRSP to its full advantage and the many benefits to be realized!
First introduced in Canada in 1957 for those who didn’t have access to a corporate pension, RRSPs are still a popular option today, as retirees often rely on income from multiple sources. Canada Pension Plan (CPP) and Old Age Security (OAS) payments alone are typically not considered enough to cover an individual’s retirement expenses.
While there are some instances where other account types might be more beneficial than RRSPs – such as a corporate account structure for business owners, or a TFSA for those in a lower tax bracket – in most cases, RRSPs can be a useful tool for building out your retirement nest egg.
Benefit #1: Tax-Deferred Income
When you contribute to an RRSP, you are deferring paying tax on this portion of your income until you withdraw from it. The rationale being that most of us will earn a lower income in retirement than during our working days, so you will be withdrawing at a lower income tax rate.
Your allowable RRSP contribution for 2020 is the lower of either 18% of your earned income for 2019 or $27,830. RRSP contributions are tax-deductible, meaning they are deducted in the calculation of your net-income and ultimately reduce the amount of tax you owe.
Here’s a quick example:
Mary earned a gross income of $100,000 in Ontario in 2020 and paid an average tax rate of 27.13% (she paid $27,133 in taxes).
Mary contributes her RRSP maximum at $18,000, reducing her taxable income to $82,000 and also reducing her average tax rate to 25.42% (she now only has to pay $20,848 in taxes).
Calculating the difference, you can see that Mary will have saved over $6,000 in taxes in 2020. As Mary is a salaried employee and her income taxes are deducted at the source, she will receive this difference as a refund when she files her taxes for 2020.
This simple RRSP calculator is a useful resource for calculating the tax impact of an RRSP contribution.
Benefit # 2: The Power of (Tax-Deferred) Compounding
Not only will you be reducing your current tax bill, investing in RRSPs also allows you to take advantage of tax-deferred growth. You can hold a variety of investments, such as bonds, stocks, mutual funds, ETFs, REITs, and more in your RRSP. If you are investing in your RRSP at an early age, you will have a long-time horizon and the added benefit of many years of compounded growth.
Example 1:
If you save $500 per month with an annual return rate of 6% compounded monthly, beginning at age 25, you would have $1,000,724 at age 65.
Example 2:
If you started saving $1,000 per month at age 45 with the same annual rate of return (6%) compounded monthly, you would only have $464,361 at age 65.
So you can certainly see the benefit of starting early and regularly! The advantage of doing so within your RRSP is that you do not have to pay any taxes on the growth or income earned on these investments until you make withdrawals from the account.
Benefit # 3: Income Splitting
RRSPs are also a great way for married and common-law couples to reduce their overall tax bill in retirement by income splitting. In this instance, a higher-earning spouse can contribute (within their contribution limit) to a Spousal RRSP on behalf of their lower-income spouse.
The spouse with the higher income claims the tax deduction, while the spouse with the lower income only pays tax on any withdrawals made from the RRSP (likely during retirement).
The following should be considered when determining whether to contribute to your partner’s Spousal RRSP:
- The contributing spouse’s tax rate in retirement: If the rate is expected to be higher than the recipient spouse’s, contributing to a Spousal RRSP would be a good way to reduce overall taxes.
- The non-contributing spouse’s tax rate in retirement
- The stability of the couple’s marital situation: A Spousal RSP is legally the property of the recipient spouse, although tax-free transfers can be ordered by the court in the event of a marriage breakdown.
I will elaborate on the tax impact of withdrawals from RRSPs in a future post, but if you and your partner are planning to use RRSPs as an income-splitting tool, you should be aware of the attribution rule. The attribution rule states that withdrawals from a spousal RRSP could be taxed in the hands of the spouse that contributed to the account if the withdrawal is made within three years (the year the contribution was made, plus two calendar years) of when the contribution was made to the Spousal RRSP. The contributing spouse will be taxed on the withdrawal in the year the withdrawal was made.
Regardless of how you use an RRSP, or if you’re interested in taking advantage of other account types, planning for retirement should be an integral part of your financial plan. If you’re unsure how to get started, or whether you’ve chosen the right option, contact us!
The Low Down is a new series where Carolina da Silva breaks down popular concepts in the world of personal finance.
Information in this article is from sources believed to be reliable, however, we cannot represent that it is accurate or complete. It is provided as a general source of information and should not be considered personal investment advice or solicitation to buy or sell securities. The views are those of the author, and not necessarily those of Raymond James Ltd. Investors considering any investment should consult with their Investment Advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decision. Raymond James Ltd. is a Member - Canadian Investor Protection Fund.