RRSP season is upon us! Time to go through the couch covers and scrounge up the last of our savings to make that all-important contribution. Let’s look at some fundamental concepts of RRSPs.
What are RRSPs?
RRSP, or Registered Retirement Savings Plans, is a vehicle created by the Federal government to allow you save and invest your hard-earned dollars in a tax deferred account. Notice the term “tax deferred”. It is NOT tax free; any money entered into the plan is allowed to accumulate tax free until the time you are required to pull it out.
What can I buy within an RRSP?
Practically all investable assets such as money, guaranteed investment certificates, government and corporate bonds, mutual funds, and securities listed on a designated stock exchange. An RRSP is NOT an investment. It is simply a plan in which you BUY investments and defer your tax on them.
Where can I buy investments for my RRSPs?
Banks, investment companies, insurance companies and stock brokers are some places you can use to buy investments within your RRSP.
When can I contribute for the current year?
The RRSP contribution period usually stretches from March 2nd of the current year to March 1st of the following year (first 60 days*). These dates are important, especially the first 60 days of the following year. These latter contributions can only be declared in the previous year’s tax return. Let’s see an example:
John contributes $3,000 to his RRSP on February 24, 2016. Because the contribution is made within the first 60 days of the year, John has to declare the contributions on his 2015 tax return. John can choose to not use the contributions and carry them forward to the following year; however the contributions have to declared on the 2015 return.
*In a leap year, your deadline is February 29th.
Can I put as much money as I want in the plan?
NO! You are limited to the lesser of 18% percent of your earned* income, or the set maximum, which is indexed every year ($24,930 for 2015). This amount is what is called your RRSP limit. You can find out your limit by looking at your previous year’s Notice of Assessment, or by going to the My Account website of the CRA. Any unused room accumulates to future years.
*Earned income to the CRA means employment income, net self-employment income, net rental income, taxable support payments etc… So not all income is “earned” income to the CRA, especially interest income, dividends and capital gains.
So my money grows in a tax deferred way, is there any other advantage to contributing to an RRSP?
Now RRSPs get really interesting! Not only does your money grow without interference from the tax man until your required withdrawal, but you also get a tax deduction to boot! Any contributions you make to your RRSP during the year get deducted from your total income when determining your net income. That’s an instant return on your investment even before your money has had time to work for you! Let’s see a simple example to understand the mechanics:
John made $40,000 during the year. He has about $3,000 to invest and is thinking of investing the money into RRSPs. At $40,000, John falls into the 15% federal tax bracket. Let’s see what the results are for John with and without an RRSP contribution:
W/O RRSP: $40,000 X 15%= $6,000 tax payable*
With RRSP: $40,000 - $3,000= $37,000 X15% = $5,500 tax payable*
* for simplicity, we have not considered the effect of non-refundable tax credits, to highlight the deduction effect. Lowering net income would increase other credits, such as medical expenses. We have also not factored in provincial taxes.
From the example above, we see that John gets an extra $500 back from the CRA for simply making the contribution.
And just like you would hear from a cheap infomercial on television, there’s more! Not only do you get the tax deferral, the reduction in taxes, but you also get the increase in certain benefits and credits, such as the GST credit, Child Tax Benefit and medical expense credit! Benefits such as the GST and Child Tax Benefit are based on your net income; since your RRSP contributions reduce your net income, you will be able to claim more of those amounts. Credits on your tax return, such as the medical expense credit, are also based on your net income; the lower your net income, the more credits you will be able to claim!
RRSP contributions really provide a big return on your investment. Not many other plans can claim that.
You keep mentioning tax deferral, when does the party end?
Unfortunately, the party starts winding down at age 71, when the CRA requires you to start withdrawing from your RRSP at set percentages which increase as you age. At that age, your RRSP converts into a Registered Retirement Income Fund (RRIF). The withdrawals are taxable income on your return. Just remember though that your money has been growing for many years without interference from the tax man, and any money not withdrawn continues to accumulate tax free.
We hope this primer has helped you understand the basics of RRSPs. In the next blog entry, we will dive into deeper waters, and see some more advanced topics on RRSPs.