Registered Retirement Savings Plans (RRSPs) are perhaps the most powerful of the registered accounts when it comes to building wealth, but with that power comes restrictions and future tax considerations. RRSPs are primarily used for retirement savings, with your money locked in until you retire, with a few exceptions.
RRSPs allow you to defer income tax. What that means is that it allows you to pay less taxes during your working years, and instead pay the tax when you take the money as retirement income (or pass away). Now why would you want to do that? Two primary reasons:
- By deferring the taxes, it allows you to save more money up front. This allows you to have more money to compound towards retirement savings.
- You’re assuming that your income during your working years will be greater than in retirement. So, by paying it on retirement income you will pay less income tax. This is running off a few assumptions however, which I’ll expand more on below.
Similar to other registered accounts, RRSPs can be seen as a bucket, in which you can hold multiple types of investments. RRSPs are funded with pre-tax income (i.e. you haven’t paid income tax on the money yet), and as long as the money stays in the RRSP, you do not pay tax. Because of these advantages there are also a lot of limitations on RRSPs.
In this article, I am going to cover:
- RRSP contributions
- Benefits of RRSPs
- Limitations/pitfalls of RRSPs
- Maximizing usage of RRSPs
RRSP Contributions
As I mentioned above RRSPs are funded with income that has not been taxed. Now, you may be asking, “my employer deducts my income tax before I ever see it, how would I get income that hasn’t been taxed?” Well there are two ways:
- Deductions into a RRSP through your employer
- Many employers are set up with a “Group Retirement Plan” through a company such as Manulife. This allows you to deduct a chosen percentage of your paycheck and put it directly into this group plan before the income taxes are deducted. These plans often allow you to select from one of their mutual funds to invest in.
- Deposit of income (that has been taxed), and a tax refund when you file your taxes
- In this case, you have already paid tax on this money. So what will happen is you deposit this money into your RRSP, and then at the end of the year, that deposit gets deducted from your taxable income. So if you made $75k, and you deposited $10k into your RRSP, the government says “we taxed you on $75k of earnings but you actually took home $65k, so we’ll return the tax you paid on that $10k.” The downfall of this is that you can be waiting up to a year for this refund to come back to you.
Contribution Limits
Now of course, there is limitations to the amount you can contribute to your RRSPs. This limit is cumulative, meaning if you don’t use it one year, the additional room in the subsequent year will be added to the remaining room. The limit for your RRSP is 18% of your earned income for the previous year, up to a maximum (the 2022 maximum was $29,210). Similar to the TFSA limits, if you exceed your contribution limit, you will pay a 1% penalty each month that those extra funds are in your account. So pay attention to your limits (you can see your contribution room in your CRA account).
Benefits of RRSPs for Retirement Savings
RRSPs have a huge advantage for retirement savings because you can have a larger base for compound growth. Because you can either deposit pre-tax dollars, or get a tax return (assuming you put that tax return back into your RRSP), you have more money to grow. Imagine you have a circumstance where you have $10k of income to invest. If you were to put that straight into your RRSP, you’d have $10k to grow. If you instead took it as income, then invested it (e.g. in a TFSA), you’d pay ~20% of it in tax (depending on your tax bracket), meaning you’d invest $8k. Now imagine your portfolio grows by 8% annually. Lets look at the growth over a few time frames (simplified example shown):
| Year | RRSP | TFSA |
|---|---|---|
| Initial Deposit | $10,000 | $8,000 |
| 1 Year | $10,800 | $8,640 |
| 5 Years | $14,693.28 | $11,754.62 |
| 10 Years | $21,589.25 | $17,271.40 |
| 25 Years | $68,484.75 | $54,787.80 |
This results in about a $14,000 increase, and that’s just with a one year contribution. Let’s run the same simulation with the same contribution each year (contributing $10k (taxed and untaxed) annually, with 8% growth) (simplified example shown):
| Year | RRSP | TFSA |
|---|---|---|
| Initial Deposit | $10,000 | $8,000 |
| 1 Year | $20,800.00 | $16,640.00 |
| 5 Years | $73,359.29 | $58,687.43 |
| 10 Years | $166,454.87 | $133,163.90 |
| 25 Years | $799,544.15 | $639,635.32 |
Now you can see that with the same outlay on your end, your RRSP has significant advantages (almost $160,000 in difference) over accounts that are funded with taxable income. And you don’t pay any capital gains tax on this growth.
Limitations/pitfalls of RRSPs for Retirement Savings
Now because RRSPs have such an advantage for growth, there is some significant limitations to how you can access this money. Other then a few exceptions (notably the Home Buyers Plan and Lifelong Learning Plans – more on these below), you will be penalized for withdrawing from you RRSPs before retirement. When you do choose to retire, there’s a couple options to handle your RRSP, outlined below.
Deferring Your Taxes
The key thing to remember with RRSPs is that you defer the income tax. This means that you will pay as much, if not more in tax. Now how can you pay more in tax? RRSPs allow you to not pay tax on the contributions or the growth of the account, but when you eventually withdraw, it’s taxed just like employment income. This means that your contributions can grow over your career, and you don’t pay any capital gains tax. Since this money has grown, you can then withdraw (and pay tax on) more than you ever contributed to your retirement savings. Now there are strategies to minimize this, but it’s still an important differentiation.
Accessing Money from an RRSP before you Retire
With the exception of the Home Buyers Plan (HBP) and the Lifelong Learning Plan (LLP), if you withdraw money from your RRSP before retirement, you will pay a withholding tax. This tax is a percentage of the amount withdrawn:
- 10% (5% in Quebec) on amounts up to $5,000
- 20% (10% in Quebec) on amounts over $5,000 up to including $15,000
- 30% (15% in Quebec) on amounts over $15,000
The withdrawals are also considered taxable income. So depending on your tax bracket, you may pay additional tax on top of the withholding tax. So withdrawing from an RRSP before retirement has heavy tax implications. As well, unlike TFSAs, you don’t get the contribution room back after withdrawal. So withdrawing (e.g.) $10,000 will forever reduce your contribution room by $10,000.
The Home Buyers Plan (HBP) allows Canadians to access up to $35,000 of RRSP funds to purchase their first home. This money will not be taxed, but must be repaid fully back into your RRSP within 15 years of the initial withdrawal. The repayment starts two calendar years after withdrawal (so if you withdrew in 2023, your first year of repayment would be 2025). There are some criteria that need to be met to use the HBP, so be sure to review before withdrawing (more info here). This program can be helpful for saving for a home, but an even more powerful tool is the FHSA – I’d put down payment money in an FHSA before a RRSP.
The other way to get money out of an RRSP before retirement without penalty is the Lifelong Learning Plan (LLP). You can withdraw up to $10,000 annually, with a lifetime limit of $20,000 for qualifying education plans for yourself or your spouse. Similar to the HBP, you have to repay this amount, but for LLP it must be repaid within 10 years. As well, there is criteria that must be met to qualify (more info here).
Accessing RRSP funds after retirement
When you choose to retire, there are three main options for your RRSPs. You can convert your RRSP into what’s called a Registered Retirement Income Fund (RRIF), you can use it to purchase an annuity, or you can withdraw the funds. If you withdraw the funds, the same withholding tax outlined above will apply.
You can convert your RRSP into a RRIF anytime after age 55, and before December 31st on the year you turn 71. When you convert your RRSP to an RRIF you can no longer contribute to it, and there a minimum required annual payout, which is a percentage based on your age (see the amounts here). This income is taxable, and is taxed the same as income that you would get from an employer (so the applicable tax brackets apply).
You can also use the RRSP funds to purchase an annuity. An annuity is essentially purchasing future earnings, so you pay X (large amount) to get Y (smaller amount) annually in income (typically about ~5% depending on duration of annuity). This can be a way to secure a certain income in retirement, and are typically provided by life insurance companies. There is no withholding taxes if you purchase an annuity.
Death of a RRSP or RRIF – What happens to your retirement savings?
When someone dies with balance in either their RRSP or their RRIF, the government treats the fair market value (what it would sell for on the market) of the account as income during the deceased individual’s final year. So if they had $1 million left, the government would treat them as having earned $1 million in taxable income in that year, and they’d be taxed accordingly. So there is potential for a huge tax bill at the time of death.
Now there is one exception to that, which is if your spouse is designated as the sole beneficiary. In that case the taxes paid can be less, but as always there are a lot of considerations.
Maximizing usage of RRSPs for retirement savings
Though RRSPs have advantages from a tax deferral and growth perspective, there are also some serious downfalls. Namely:
- With a couple exceptions you cannot access this money until you retire
- When you retire, this income is treated as taxable income, and you pay the applicable tax rates. You are typically running under the assumption that your taxable income will be less than your working years, but you are also betting that tax rates won’t be higher than they are now. So you may ultimately pay more tax in retirement. It’s important to be aware of this risk.
- There is a significant tax bill upon death, meaning less goes to your family and loved ones.
What I really want to stress here is that you are ultimately not saving tax on your retirement savings, you are just deferring it. The government will get that taxable income at one point or another, whether you pay it now, in retirement, or at death. So though there is advantages, that is certainly something important to consider.
With that said, there are two notable ways where I see a huge amount of value in RRSPs for retirement savings:
- Employer matching – a lot of employers offer to match your RRSP contributions up to a certain percentage. E.g. they may offer to match your contributions up to 5% of your salary. This is equivalent to a 100% return on that money, so you should absolutely take advantage of that whenever possible.
- Home Buyers Plan – When saving for your first home, you can save the tax on up to $35k of earnings. This can greatly accelerate your savings rate.
Conclusion
There is a lot of advantage to RRSPs when it comes to growing your retirement savings. But there is also drawbacks when it comes to access to the funds and taxation. It’s important to consider all the implications before putting all your money into your RRSP. Think about when you’ll need access to this money, and if RRSPs make sense for your situation.
If you’re wondering where to put your money first, see my article here:
If you’re looking for more flexibility, see Tax Free Savings Accounts (TFSAs). For an alternative to RRSPs, check out infinite banking.