What is an RRSP (Registered Retirement Savings Plan)?

How does an RRSP work?

To truly understand how an RRSP works, it’s important to take a closer look at the three key aspects of the plan: contributions, earnings, and withdrawals. 

Contributions towards an RRSP

You can contribute up to 18% of your previous year’s earned income, up to a limit set by the CRA, which changes each year. 

Keep in mind, if you don’t meet your maximum yearly contributions in previous years, the unused contribution room is carried forward to the next year. You can take advantage of that unused contribution now or when your income is higher and there may be an opportunity for greater income tax deductions.

Investment earnings and tax-savings

RRSPs do not generate interest on their own. Instead, interest is earned through the savings or investment assets held within an RRSP. These assets can encompass a variety of savings or investment vehicles, including mutual funds, stocks, ETFs, cash, and GICs.

The income you earn from investments held within your RRSP grow tax-deferred as long as the money remains within the RRSP. Once the investments are withdrawn, however, the funds are taxed as income at the account holder’s marginal tax rate.

Withdrawals

Here’s the thing: unless you’re in a locked-in plan, you can technically withdraw money from your RRSP any time you’d like. You are just required to pay taxes on the money you withdraw before the required age of 71. 

Once you have reached 71, you have three options. The first is to withdraw your funds in one lump sum, assuming you want all the money at once. If you choose this option, you’ll have to pay withholding tax.

The second option is to convert the RRSP funds into a RRIF. If you choose this route, you’ll receive regular income from your account and will be required to withdraw a minimum amount each year, which is subject to income tax.

The third option is to purchase an annuity. By purchasing an annuity, you get guaranteed payments for a defined period.

Use-case example

Let’s say your annual income is $80,000 and that you’re up-to-date on previous contributions. You want to contribute the maximum amount this year so you contribute 18% which amounts to $14,400. When it comes to paying your taxes, the CRA will consider your annual tax income to be $65,600 ($80,000 - $14,400). 

Of course, since that money is tax-deferred, not tax-free, when you eventually withdraw your RRSP, you will you will be taxed on your withdrawals at your marginal tax rate. But hopefully not for a long time.

What investments can you hold in RRSPs?

You can hold a wide array of assets in an RRSP – and can even move the money around among the vehicles should you choose to. 

Qualified investments include:

• Cash
• ETFs
• GICs
• Mutual Funds
• Gold
• Savings Account
• Bonds
• Securities and Stocks

4 benefits of using an RRSP to save for retirement

There are many ways one can save for retirement. Stuffing wads of cash under the mattress, for example. But when it comes to setting yourself up successfully for the future, an RRSP offers some advantages over other options, including creative mattress-stuffing. 

1. Tax-deferred growth

As we saw earlier, any contributions made to one’s RRSP won’t be taxed until withdrawal, a benefit that applies to your investment earnings too. Chances are good that your marginal tax rate will be higher during the years you’ll be contributing to the RRSP than it will be in retirement. This means you’ll be paying less in taxes on the income when it’s withdrawn.

2. Tax-deductible contributions

Anything you contribute to your RRSP may reduce your taxable income. In practical terms that means you will likely owe less during tax season – or receive a larger refund. 

3. Borrow for a first home

One of the biggest and most stressful purchases you will ever make is your first home. Which is why it’s important to do it right, leveraging every incentive and advantage you can. When you use your RRSP to save for your first home, you’re allowed to withdraw up to $60,000 for a down payment under the Home Buyers' Plan (HBP), conditional upon it being repaid accordingly.

4. Borrow for education

If you want to return to school, an RRSP can make that dream viable. You can withdraw funds from your RRSP through the Lifelong Learning Plan (LLP) to help pay for full-time education and training. Up to $20,000 can be withdrawn tax-free, conditional upon it being repaid accordingly.

Tips on how much to contribute to your RRSP

If you decide the RRSP is the best account to help build your retirement savings, the question becomes: how do I determine how much to contribute, and when?

The basic rule is to contribute as much as you can, taking into account your financial needs today and understanding that any withdrawals before retirement are taxed as income. Can you put the maximum amount allowed? If yes, do it, knowing you’ll reap the rewards. If not, simply come up with a number that makes sense to you.

Consider the following before making any payments.

Contribution limit: 

As we saw above, there are limits on how much you can contribute to your RRSP each year. Basically, the CRA calculates your annual RRSP contribution limit as your unused RRSP deduction room at the end of the preceding year, plus the lower of:

• 18% of your earned income in the previous year
• the annual RRSP limit (maximum contribution amount for the current tax year). And make sure to remove any pension adjustments from the last year.

Check your RRSP balance:

Be sure you’re contributing within your limit. Log onto your CRA My Account to find your RRSP balance. If you’ve gone over the contribution limit, you’ll be notified here.

Contribution rules:

The CRA allows you to make contributions in the first 60 days of a new year to be applied to the previous tax year.

You can make contributions to your RRSP until the year in which you turn 71, up to the contribution room provided by the CRA.

Flexibility to carry forward RRSP contribution room:

If money is tight and you’re unable to contribute one year, worry not. You’re allowed to carry forward your RRSP contribution room and use it in the future. Use BMO’s RRSP Calculator to estimate how much your plan will be worth by the time you retire – and how much income you can expect it will offer you each year.