Although we are all young now, at some point, we will all retire, and when we do, it is important that we have adequate savings to continue a comfortable life. Given the importance of this, the government has provided for tax-advantaged accounts that let you build up retirement savings. The biggest one is an RRSP. The idea behind is simple, it provides a way to deduct taxes from your income, while also sheltering those contributions from capital gains taxes until their redemption. This favourable treatment incentivizes retirement savings. However, it does have contribution limits and withdrawal requirements so getting a better understanding of this crucial account could be very beneficial.
Setting up an RRSP
Normally, this can easily be set up as an account at a financial institution (normally a bank or credit union). This is the place where you will make your deposits for the RRSP, and where any potential investments and subsequent withdrawals might be made. If you want to make your own stock/investment picks, then you can set up a self-directed RRSP. There are limits to the types of investments you can make, though these limits are mainly there to try and limit gambling as much as possible. These available options include Mutual Funds, most equities & bonds as well as buying options (while only covered calls can be sold).
Another interesting option is to set up a spousal RRSP. This allows you to make contributions, but also allows your spouse to withdraw. The idea behind this is that a higher income contributor can benefit from the tax deduction, while when withdrawing the lower-income spouse can benefit from their presumably lower tax bracket.
Contributing & Tax Deductions
One of the main incentives for actually utilizing an RRSP, and one of the biggest advantages is the reduction in tax paid by contributing. Now, the contribution limit is 18% of your previous year’s income up to $27,830. Essentially, this contribution is deducted from your taxable income. For example, if you had an income of $150,000, you would only be able to deduct $27,000 (18% of income), and would result in a taxable income of $123,000. This would save you $14580 (under current tax brackets in Canada & Ontario), which, instead of going to the government, instead goes to a savings account under your name, which you can invest. This materializes in the form of a tax refund.
Carrying over Contribution Limit & Tax Shelter
Now, the other massive benefit of the RRSP, and one that is very relevant to us investors, is the fact that any gains made in the account are non-taxable until they are withdrawn, likely decades from now - allowing you to compound investment returns. Another thing to keep in mind is that you don’t have to contribute to your RRSP for fear of losing contribution room if you need the money. Luckily, you can carry-forward RRSP contribution room indefinitely. The only real consequences are that you don’t get the deduction in that year, and if you combine them the next year, you might be in a lower tax bracket, meaning less savings. Additionally, you lose out on the potential compound interest for that year
Withdrawal & Exceptions
Now, unfortunately, after you’ve accumulated all of these savings and made some hopefully excellent investments, it is now time to withdraw your money and the government now wants their cut. They actually charge you tax twice (basically to recuperate all their tax losses from your deductions and potential capital gains). You basically ave to hope that your investments and the time value of money outweigh the extra tax treatment. Now, as we’ve covered in other articles, this is almost guaranteed, but just to convince you again: $1000 invested at an 11% compound rate over 60 years with $10/weekly contributions leads to over $3,000,000.
The government first charges you withholding tax on any withdrawals, ranging from 10% to 30% depending on your withdrawal amount (up to 5k is 10%, till 15k it's 20%, after 15k it’s 30%). Afterwards, you then have to include these withdrawals on your income and pay income tax on them. All in all, this makes withdrawals costly, and normally means that it is usually better to leave the money in so that it can compound. Luckily, there are two substantial exceptions to this that allow you to avoid the penalties of withdrawals.
The first is the Home Buyer’s Plan. Essentially, when you are buying your first home it allows you to withdraw up to 35k (usually to facilitate a down payment), without penalties (though this amount must be paid back over 15 years). Finally, the Lifelong Learner’s Plan, lets you withdraw up to 20k (in 10k yearly instalments) over a max period of 4 years in order to fund qualified education. Unfortunately, this doesn’t apply to children’s education, so it is unlikely that us students can take advantage of it (normally not having 20k to withdraw from an RRSP in the first place, or if we did, no need to withdraw it).
All in all, I hope that this guide helps you on your basic journey through RRSPs and gives you an idea of one of the only places where ordinary Canadians can actually limit their tax payments.
By: Mateo Gjinali
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