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What is an RRSP & How Does It Work?

Andrew Goldman

Andrew Goldman has been writing for over 20 years and investing for the past 10 years. He currently writes about personal finance and investing for Wealthsimple. Andrew's past work has been published in The New York Times Magazine, Bloomberg Businessweek, New York Magazine and Wired. Television appearances include NBC's Today show as well as Fox News. Andrew holds a Bachelor of Arts (English) from the University of Texas. He and his wife Robin live in Westport, Connecticut with their two boys and a Bedlington terrier. In his spare time, he hosts “The Originals" podcast.

RRSP is an acronym for “registered retirement savings plan.” This definition sounds mighty dry when you consider how RRSPs are superheroes of modern retirement planning for Canadian — true tax-obliterating, retirement-enriching wonders of the modern world.   

Fasten your seatbelts for our whirlwind primer on the following RRSP related topics, several of which you might want to specifically read about in more detail:

Should these topics whet your appetite and leave you hungry for more on the subject of retirement, you also might want to check a more comprehensive guide to retirement planning.

What’s an RRSP and how does it work?

An RRSP is what’s called a tax-advantaged account, meaning that the government created them specifically to provide tax breaks to those who invest money in RRSPs as a way to motivate them to put away money for their retirement.

What exactly is the meaning of the term “tax-advantaged”? To you, Canadian taxpayer, tax advantaged means in practice “free government money.” Here's how Jeff Nichols, Portfolio Manager puts it.

You can almost think about the RRSP as the CRA saying—you know what, don't pay us the tax this year. Pay it over the next 40 years when you'll probably be paying less tax. We don't get many handouts like this, so we should take full advantage of them!

In this specific case, RRSPs are what’s called tax-deferred, meaning any money you contribute will be exempt from CRA taxes the year you make the deposit, and will only be taxed years down the line when you withdraw it. RRSPs are an amazing way to cut down a current-year tax bill.

Benefits of the Registered Retirement Savings Plan

Here’s how a tax-deferred account like an RRSP works. Let’s say you make $70,000 a year and you decide to put the maximum allowable into your RRSP—$12,600. When tax day comes around, the CRA will treat you as though you earned just $57,400.

Now, tax-deferred doesn’t mean tax-free, and you will eventually have to pay taxes when you withdraw your money years down the line, but by the time you do so, you’ll be retired, your income will almost certainly be smaller and, thus, your tax rate be lower than it is now.

RRSP Contribution Limit

Because RRSPs are registered accounts, they’re subject to certain rules. One of the most important rules concerns the amount of money you can contribute to the account in any given year; it’s either 18% of your past year’s income or a maximum amount, whichever’s smaller. The amount changes, but you can find this year’s contribution limit here. You can also catch up if you didn’t max out your investments in earlier years; to find out how much you can contribute, check out the Notice of Assessment that you got after filing your taxes last year.It’s important to remember that even though you might have contribution room left over from previous years, you will not accumulate deduction limits. So imagine you’ve made ​36,000 into your account, but you’ll only be able to deduct $18,000 of income from your current year taxes.

RRSP vs GRRSP

Only one letter separates the RRSP from the GRRSP, but that one letter could mean a difference of tens, even hundreds of thousands of dollars in retirement. Group RRSPs are just company-administered RRSPs. And though they have a few disadvantages, like limited investment options and possibly higher fees, they have one extraordinary advantage—employers will often match a portion or even every dollar of your GRRSP contribution.

With this this in mind, you might think of your retirement savings as one of those fabulous champagne towers that you’ve never actually seen at any wedding you’ve personally attended. The top cups always get filled first before anything below gets even a drop of champagne. If money is the champagne in this metaphor, you the absolute tip top cup should be your employer’s GRRSP. That free-for-the-taking employer matching contribution will make an extraordinary difference in terms of compounding gains over the long term. And because you can have your employer withhold funds to deposit directly into your GRRSP, not only will you not be tempted to spend that portion of your pay, the money deposited will be pre-tax, meaning that a larger amount of money will get invested right away, versus investing yourself and having to wait six months to a full year to get that money back though a tax refund.

RRSP vs TFSA

Since both TFSAs and RRSPs are phenomenal in their respective ways, this a kind of a Batman vs. Superman question, one that begs the question why you should have an RRSP when a TFSA is similar and has no early withdrawal fees.

Here are a few of the biggest factors to consider:

  • If you haven’t contributed much towards your retirement and you happen to have access to a pile of money right now through, say, a bonus, or inheritance, a TFSA might be the best option for you, since RRSPs have what's called an annual deduction limit, meaning that you won't be able to deduct over a certain amount in any given year. The number for 2020 is $27,230 but you can find past, current and future deduction limits on this CRA page.

  • TFSA are designed to be easily accessed before retirement if the funds are needed—which is good, especially for those with a more immediate goal in mind like buying a house or car. TFSAs are less good if you happen to be the type who’s never been able to resist smashing a piggy bank.

  • If the funds are for your retirement, for tax reasons, TFSAs are generally considered preferable to RRSPs for those earning less than $50,000 a year.

Over contribution to RRSPs

What happens if you contribute too much to your RRSP? The CRA’s pretty forgiving on these matters. First, you’ll get a nice bit of cushion; any amount up to $2,000 over your annual limit will be forgiven (though it won’t be considered tax-deductible). If you go over that, the CRA will likely mail you a notice that you’ve over contributed and encourage you to vamoose that excess dough. Should you fail to, they’ll begin to assess a penalty of 1 percent on that over contribution, assessed monthly, for each month you‘re over the limit. The CRA understands that mistakes happen, and should you find yourself in this situation, it may be worthwhile to do a bit of research on the topic of penalties and resolutions and seek forgiveness of this penalty.

RRSP Home Buyers Plan

Though RRSPs are often regarded as an impenetrable lock box of retirement savings that will explode in your face if you try to access it before retirement, the Home Buyers Plan (HBP) provides one notable exception to that idea. The HBP, a program through the Canada Revenue Agency (CRA), allows eligible first-time homebuyers to withdraw up to $25,000 tax-free from their RRSP to be used towards a down payment on the purchase of the home. So, you can take advantage of the tax deductions that RRSP contributions provide while saving for a down payment on your home. Then, you can withdraw the funds tax-free and use them towards a home. But one thing you must remember: because HBP is like you loaning yourself money for a house, there are rules with great tax-implications you’ll need to follow. Since they’re a heck of a lot more accessible than RRSPs, if you’re pretty sure you’re going to be buying your first house soon, a TFSA might be the wiser account for your needs.

How to open an RRSP

You obviously have many choices of institutions where you might open an RRSP, but consider trying to find one that requires no minimum investment, charges low fees, and provides unlimited phone support from knowledgeable humans for every client. Opening an RRSP requires very little and can easily be accomplished from the comfort of your own home. Once you've chosen an investment provider, you'll likely be asked to provide your email and a create password that you'll use to access your account. Then you'll fill out a very brief risk survey to determine what sorts of investments will best fit your needs given when you hope to retire and how aggressive you can afford to be with your investments in the meantime. Then, all that's left to do is fund the RRSP, easily accomplished by linking a savings or checking account to your investment account.

Ready to take five minutes to open the finest RRSP ever devised? Sign up to Wealthsimple, the only automated investing services to offer all of its client’s unlimited human support. Every Wealthsimple client gets state of the art technology, low fees and the kind of personalized, friendly service you might have not thought imaginable from a low-priced investment service.

Last Updated September 17, 2019

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