What an RRSP Is
A Registered Retirement Savings Plan, or RRSP, is a special type of investment account designed to help Canadians save for retirement. The main advantage of an RRSP account, as compared to a regular investment account, is the tax benefits it offers. We'll discuss these benefits in detail throughout this tutorial.
For now, just know that the contributions made to an RRSP - which can be made up to a certain limit - are tax free and that the money within an RRSP can compound without your having to pay taxes on the gains.
What an RRSP Is Not
An RRSP is not an investment in itself. You'll often hear people talking about the "RRSP they bought"; however, technically, this is both incorrect and impossible. An RSSP is simply an account that holds other investments. It's the same as a regular brokerage account - you don't invest in your brokerage account at Royal Bank or TD Canada Trust, you open an account in which you hold investments. You can't "buy" an RRSP: you buy an investment in the RRSP account to which you contribute. This is a common misconception, and we'll bet that you will now be able to make this clarification next time you and your friends are talking about RRSPs.
Here is a summary of some of the features of an RRSP account:
- Registered with the Canadian federal government
- Legally recognized as a trust
- Offers tax benefits over regular investment accounts
- Can hold many different types of investments
Tax benefits are the main motivation for contributing to an RRSP. By not taxing Canadians on the funds they contribute to their RRSPs, the government rewards those who save for retirement and encourages further saving. However, the government doesn't do this out of generosity. Because of the government costs involved in funding poorly planned retirements, the government recognizes the importance of ensuring that Canadians make their own provisions for their post-work lives.
RRSP tax benefits come in two forms:
1. Tax-Deferred Growth
All investments within an RRSP account grow tax deferred. In other words, any profits made on investments within an RRSP account in the form of interest, dividends or capital gains are not immediately taxable to you as income. Later in the tutorial, we'll go through some examples showing just how powerful this benefit can be.
Note that there is a difference between tax deferred and tax free, however. RRSP investors do have to pay taxes on the profits in their RRSP, but this does not occur until the funds are withdrawn. Tax deferral remains a benefit because, in theory, income tends to be lower in retirement than in your peak earning years.
2. Tax Credits
The second major tax benefit comes in the form of a tax credit. What this means is that your taxable income is reduced by the amount you contribute - up to a certain point.
If Joe makes $34,000 in 2010, the maximum amount the government will allow him to contribute to his RRSP in 2010 is either 18% of his earned income or $22,000 (the cap on RRSP investments for 2010), whichever is lower.
Maximum Contribution = Lower of $22,000 or 18% of Earned Income
= Lower of $22,000 or $6,120
Because $6,120 is less than $22,000, the maximum amount that Joe can contribute to his 2010 RRSP is $6,120. This means that Joe only has to pay tax on $27,880 of his income ($34,000 - $6,120 = $27,880) if he contributes his maximum to his RRSP. Because Joe contributed to his RRSP, he receives $6,120 in tax credits.
If you don't already have an RRSP account, what you've just read has probably caught your attention. But who can contribute? What makes you eligible? We'll answer these questions and more in the next section of this tutorial. We'll also tackle the debate between managed and self-directed accounts.
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