When planning for our future and saving towards retirement, we often get deterred by the age limit when we have to stop contributing. If this rings true with you, you should consider opening a Registered Retirement Savings Plan (RRSP), as the age limit of contributions is 71 years old!
So, as long as you earned any income in the previous tax year and you’re under 71 years old, you can open and contribute towards an RRSP.
What is an RRSP?
The Canadian government introduced RRSPs in 1957 to help Canadians save for their retirement. One of an RRSP’s primary benefits is that the tax on an RRSP’s contributions gets deferred until you retire.
The benefit of having your tax get deferred is that your income will be lower than what it currently is at retirement, making your tax rate lower than what it is presently.
Your RRSP contributions are tax-deductible, and any gains generated in your account remain tax-free until you make withdrawals.
RRSPs are registered accounts. Therefore they’re subjected to specific rules imposed by the government. Every year you will have the opportunity to contribute up to 18% of your income from the previous tax year. For 2021, there’s a maximum contribution limit of $27,830.
Unused contribution room will get carried forward indefinitely if you don’t use all your contribution room for the current year. If you’re unsure of what your contribution limit is, you can find it on the Notice of Assessment (NOA) that gets issued by the Canada Revenue Agency (CRA) for the previous year’s tax return.
Your RRSP contribution limit will get lowered by contributions made to a workplace pension, also known as a Pension Adjustment (PA). As mentioned before, you must stop contributing towards an RRSP at the end of the year you turn 71 years old.
What Happens When You Over-Contribute to an RRSP?
Contributing more than what the government allows will result in you getting a penalty tax of 1% per month on the excess amount. This penalty is only on the excess contribution amounts exceeding $2,000, as everyone gets a lifetime wiggle room of $2,000 before any penalties kick in.
The penalty tax will fall away should you withdraw the excess amount from your RRSP.
Withdrawing From Your RRSP
Withdrawals from your RRSP are allowed at any time, but the withdrawn amount will immediately get taxed after withdrawing it. Depending on your withdrawal amount, your bank will withhold the taxes and, on your behalf, pay it to the government.
You will also get taxed on the amount withdrawn. This amount will get included in your taxable income for the year, and more taxes could get paid depending on your tax bracket.
Should you make a withdrawal before retirement, you will permanently lose that part of your contribution room.
RRSP Withdrawals That Don’t Get Taxed
Canadians have an option to withdraw from their RRSP without losing their contribution room and incurring taxes. These tax-free withdrawals include as follows:
- Lifelong Learning Plan (LLP) – You can withdraw up to $20,000 from your RRSP to pay for your or your spouse’s further education. You will get ten years to pay back the withdrawn amount.
- Home Buyers Plan (HBP) – If you’re a first-time homeowner, you can withdraw up to $35,000 from your RRSP to buy or build a home. If you’re a couple, you can withdraw up to $70,000 ($35,000 each). You will then get 15 years to repay the money to your RRSP.
What to do When You Retire
There are three things you can do with your RRSP when you retire (or a combination of all three):
#1: Purchase an Annuity
You have the opportunity to buy an annuity that will pay you an income during retirement. This can be a life annuity or term-certain.
#2: Convert Your RRSP to an RRIF
Your funds can get transferred into a Registered Retirement Income Fund (RRIF). Your funds will remain invested on a tax-deferred basis, although tax is still payable upon withdrawals. You have a minimum income that needs to get withdrawn annually and get reported on your income tax return.
#3: Make a Lump-Sum Cash Withdrawal
Taxes will get levied by CRA on the cash based on your marginal tax rate.
What Happens When You Die?
When you die, your RRSP will get seen as having been cashed out. The proceeds will get added to your estate and get taxed on your last income tax return. A few things can happen depending on who your beneficiary is.
- Qualified beneficiary – If your spouse were a designated beneficiary, they would get to transfer the funds over to their RRSP or RRIF. Taxes will get paid once they start withdrawing from the account.
Designated beneficiaries who are financially-dependant children can purchase an annuity before turning 18 years old, roll over the RRSP into a Registered Disability Savings Plan (RDSP), or cash out the money.
- Non-qualified beneficiary – These beneficiaries include charity, your estate, or a financially dependant adult child (your grandchild). The amount transferred to a non-qualified beneficiary gets reported in your final income tax return and will get taxed appropriately.
If you’re new to investing and especially young, an RRSP will offer you many benefits, such as compound growth over the long term and withdrawals to fund your studies or buy a home for the first time.
You will also benefit from your contributions towards an RRSP being tax-deductible. Once you retire, you will benefit from a lower tax rate when you start withdrawing from your account.
An RRSP is an excellent choice when diversifying your portfolio, but most importantly, you’ll get to make all your retirement goals a reality.