Posted by February means it is RRSP season! This is the time when your email accounts fill up with reminders to contribute.Aads are nudging you to put your money into RRSPs.
Before the advent of the TFSA, RRSPs was a popular choice for Canadians to sock away money for retirement (excluding employer pension plans).
When my brother first started to work, he followed the general advice of “contribute to your RRSPs”. Except he wasn’t in a high income tax bracket, which resulted in a low tax refund. He looks back and says it’s one of the dumbest investment decision he’s made. It’s because he didn’t see as much benefit from it as he envisioned.
He’s not the one. Surveys show that 30% of Canadians don’t understand the tax implications of the RRSP.
It is crucial to understand the tax implications of using the RRSP. Or else you might regret your choices when you end up with higher tax bill in your retirement than in your earning years. No one should pay more to the tax man than they need to.
In a series of posts throughout this month, we’ll go from understanding basics of the RRSP to maximizing the benefits of the account. Let’s begin!
Basics of the RRSP
The RRSP is a tax-deferred investment account. The main feature of the RRSP is to not pay personal taxes on the contribution amount (and claim a deduction on their tax return). The tax is deferred, as any amount only becomes taxed when it is withdrawn from the RRSP account.
It’s important to know that the RRSP is not exempt from tax. An exemption means you don’t have to pay taxes at all. The RRSP is merely a tax deferral mechanism or a “don’t pay tax now, pay tax later” concept.
The RRSP comes with some important concepts, which makes it sound complicated:
- Taxable income is the amount of income that the government will tax you on. The lower the taxable income, the lower your taxes payable.
- Deduction limit (aka contribution room) is the amount of money that an individual can deposit into the account in the tax year without penalties. (For simplicity, we will ignore that there’s $2,000 of wiggle room for over-contributions). You add to your deduction limit through earned income, up to a fixed dollar maximum per year. You reduce your deduction limit when you deposit cash (or transfer assets like stocks) into your RRSP. Any unused contribution room can be carried forward to a future year, so there’s no concern of “use it or lose it” in that year.
- RRSP deduction is the amount you choose to reduce your taxable income on your personal tax return. It is possible for you to contribute money, but not deduct the full amount in a given tax year. This could happen if your taxable income is low in the year you contribute, so you delay taking the deduction until a future year. If you do this, any contributions that you did not use to reduce your taxable income becomes unused RRSP contributions for you to carry forward to another year.
To review what your deduction limit and unused RRSP contributions are, you can review your annual Notice of Assessment that the CRA issues to you after you file your taxes.
Example – Rebecca
- Rebecca’s 2020 Notice of Assessment states a $10,000 of deduction limit with $1,000 of unused RRSP contributions. Her 2021 taxable income was $50,000
- This means that Rebecca can contribute up to $10,000 into an RRSP without penalties.
- In a previous tax year, she had contributed $1,000 more than she deducted. In this year, she can claim a RRSP deduction of up to $1,000 against her taxable income from her unused room.
Scenario 1: Rebecca does not contribute anything into her RRSPs in 2021
Rebecca can choose to claim up to $1,000 from her unused RRSP contribution amount against 2021 taxable income to reduce it to $49,000. Alternatively, she can continue to carry forward the $1,000 and her 2021 taxable income remains at $50,000.
Scenario 2: Rebecca contributes $3,000 to her RRSPs in 2021
By contributing, Rebecca will reduce her deduction limit by $3,000. She can now claim a deduction of up to $4,000 ($1,000 unused contribution room from a prior year, plus the $3,000 contribution in 2021). This allows her to reduce her taxable income to $46,000 if she deducts the maximum. Alternatively, she can carry forward the $4,000 as unused contributions and her 2021 taxable income remains at $50,000.
Now that you understand the basics of the RRSP, let’s get into why this account is powerful in growing your retirement savings. But it does come with some caveats.
My next post will walk through the tax deferral benefits of the RRSP and how to save money.