Investing 101: What is an RRSP?
Updated: Aug 26, 2021
As you plan for your future financial goals, investing will become an essential part of your financial life. If you’re not already saving, get started by learning how to save money by building a budget with this quick article. Once you’ve started saving, you’ll increase your long-term wealth by investing and growing your savings over time.
There are two types of accounts that Canadians can invest in, registered and non-registered accounts.
Non-registered investment accounts
A non-registered investment account is an account that is not registered with CRA as an RRSP or TFSA. Any investment return within a non-registered investment account is subject to taxation each year. Paying tax on your investment growth reduces the availability of capital for further investment. This reduction can limit your growth over time.
Registered investment accounts
There are certain types of accounts which you can register with CRA to shelter investment earnings from tax. There are two types of registered accounts, RRSPs and TFSAs.
So what is an RRSP? This article focuses on RRSPs and the benefits of investing in these types of accounts. You’ll learn the rules around withdrawing from RRSPs as well as how to use your RRSP through the Home Buyers Plan and Lifelong Learning Plan.
If you want to find out more about TFSAs check out this blog article.
What is an RRSP?
You may have already heard about RRSPs but are unsure of how they work. This type of account allows your investments to grow without increasing your taxable earnings. Since growth in non-registered investment accounts is subject to taxation, your overall rate-of-return is lower than a registered account. With an RRSP, the gains held in this account are exempt from taxation for the duration they are held in the account.
Eligible Canadians can invest in RRSPs up to the age of 71. Once reaching 71, you must begin withdrawing from RRSPs. Some minimums apply to your withdrawing from RRSPs each year. Income drawn from your RRSP gets added to your income and becomes taxable. Any lump sum withdrawals will likely be taxable at the top nominal tax rate.
The Canada Revenue Agency sets RRSP contribution limits each year. The contribution limit for 2020 is 18% of your annual income up to a maximum of $27,230 for the year. You can face tax penalties for over-contribution, so be careful to watch how much you invest in any given year. You can carry unused contribution room forward, allowing you to increase the amount you contribute to your RRSP if you have unused room from prior years.
Tax Benefits of Investing in an RRSP
There are two main reasons to invest in an RRSP. The first reason is that you’ll receive an upfront tax benefit. Any RRSP contribution within a calendar year is deducted from your taxable income for that year. This benefit reduces the amount of tax paid in a year, deferring the income to the later years in your life when you’ll likely earn less than in your peak earning years. This tax deferral can save you tens of thousands of dollars throughout your lifetime.
The second reason to invest in an RRSP is the shelter of any investment gains within the account. In non-registered accounts, the income generated from your investments is taxable in the year that it’s earned. The tax paid reduces the availability of capital for future investment, limiting your long-term growth potential. RRSPs shelter you from this taxation allowing you to increase your wealth at a faster pace due to the benefit of compounding returns.
If you’re married or in a common-law relationship, you may be eligible to contribute to your spouse’s RRSP. There are two advantages to contributing to your partner’s RRSP. If one partner earns more than the other partner, contributing to a spousal RRSP allows the higher-earning spouse to deduct the contributions from their income, further reducing their tax liability.
The second advantage of contributing to a spousal RRSP is to reduce your tax liability upon retirement. For example, if one spouse has a pension plan provided by their employer, it may make more sense for that spouse to contribute to a spousal RRSP to reduce the couple’s taxable income after retirement since minimum withdrawal rules could increase that partner’s retirement income and tax liability.
Spousal RRSP contributions come with attribution rules which govern when funds your spouse can withdraw the funds without adding the income to the contributing spouse's taxable earnings. New contributions must stay within a spousal RRSP for at least three years to avoid increasing the contributing spouse’s taxable income upon withdrawal.
Withdrawing from RRSPs
You can continue to contribute to your RRSP up to the age of 71. Once you reach 71, you must start withdrawing a minimum amount beginning in December of that year. The minimum withdrawal is based on the value of your RRSP at retirement. At this point, you can convert your RRSP account into a Registered Retirement Income Fund (RRIF) or annuity. This income becomes taxable at the nominal tax rate applicable to your annual income.
Home buyer’s plan (HBP)
If you’re planning to buy your first home, saving in an RRSP can help you reach that goal. The RRSP Home Buyer’s Plan allows withdrawing from RRSPs for the down payment on your first home, without subjecting the funds to tax-withholding. Each first time home buyer has this benefit and may use up to $35,000 towards their down payment.
When using your RRSP for a down payment, you will have to repay this money into your RRSP. Your repayment must begin within 2 years of buying your first home, but you’ll have 15 years to repay the total amount. So if you use the home buyer’s plan for the full $35,000, you’ll have to repay $2,333.33 per year starting two years after moving into your new home.
Lifelong learning plan (LLP)
Education is an important part of creating a strong financial future. Did you know that you can use your RRSP to fund your education? To help make education more affordable for all Canadians throughout their lifetime, the CRA allows you to withdraw up to $20,000 from your RRSP towards funding your education without increasing your taxes or losing contribution room (read more about contribution room below).
With the LLP, you’re eligible to withdraw up to $10,000 per year over four years. The most you can withdraw for education is $20,000. You’re responsible for repaying any funds used from your RRSP towards your education over ten years.
You can use the LLP to fund your education or that of your spouse or common-law partner. You cannot use this program for your children’s education. The government offers Registered Education Savings Plans (RESP) as well as top-up grants to help you save towards your children’s education.
Early RRSP withdrawals
You can withdraw from RRSPs at any time, but the withdrawal will be subject to tax-withholding (except under the HBP & LLP). Taxes will be withheld from your withdrawals in the following amounts:
10% of withdrawals up to $5,000
20% of withdrawals between $5,001 and $15,000
30% of withdrawals over $15,000
Additionally, if the withdrawal increases your taxable income above the 30% nominal tax-bracket, you’ll be subject to more taxation.
Loss of RRSP contribution room
If you withdraw from RRSPs before retirement, you’ll face a permanent loss of your contribution room. This means that if you withdraw $10,000 from your RRSP (outside of the HBP & LLP), future contribution room isn't increased to allow re-depositing the withdrawn amount. This point is very important as there can be penalties for over-contribution to a registered account.
Who is an RRSP for?
With several types of accounts available for investing, before choosing an RRSP, you should ask if an RRSP is right for you. Due to early withdrawal tax-withholding and over-contribution penalties, this type account might not be right for you depending on your goals for investing.
RRSPs are designed mainly for three types of investors:
First time home buyers - someone who has never been on title of a property in Canada; someone who has not been on title of a property for at least four years; someone who has owned property but has recently been divorced or legally separated
Investing for retirement - if your goal is to set aside investments for retirement and you don’t anticipate needing access to these funds prior the later stages of your life
High-income earners - Canadians who have an ability to save at least $27,230 each year - or $54,460 for those looking to contribute towards a spousal RRSP as well
Lower-income earners - Canadians who aren’t able to save the maximum RRSP withdrawal limit but still want to save for retirement can benefit from an RRSP account. Depositing money into your RRSP will result in a tax-deduction which can increase your tax refund
An RRSP is a tax-efficient way to invest. It allows you to reduce your taxable income today and defer that income to a later stage in your life. Though the contribution limits and withdrawal rules can limit benefits, RRSPs are a great way for Canadians to grow wealth.
Additionally, programs such as the Home Buyer’s Plan and the Lifelong Learning Plan, which allow you to access your RRSPs to achieve your homeownership and education goals without increasing your tax liability and losing contribution room are great aspects of the RRSP program. Maximize the many benefits of investing in RRSPs to increase your long-term wealth and protect your hard-earned income from CRA.
Want an easy way to invest in an RRSP? Check out this blog article on Moka, one of 2021’s best investment apps available.