What Is a Registered Retirement Savings Plan (RRSP)?
A Registered Retirement Savings Plan (RRSP) is a retirement savings and investing vehicle for employees and the self-employed in Canada. Pre-tax money is placed into an RRSP and grows tax-free until withdrawal, at which time it is taxed at the marginal rate. Registered Retirement Savings Plans have many features in common with 401(k) plans in the United States, but also some key differences.
The growth of an RRSP is determined by its contents. Simply having money in an RRSP is not a guarantee that you may retire comfortably; however, it is a guarantee that the investments will compound without being taxed, as long as the funds are not withdrawn.
Understanding Registered Retirement Savings Plans (RRSP)
Registered Retirement Savings Plans were created in 1957 as part of the Canadian Income Tax Act. They are registered with the Canadian government and overseen by the Canada Revenue Agency (CRA), which sets rules governing annual contribution limits, contribution timing, and what assets are allowed.
RRSPs have two main tax advantages. First, contributors may deduct contributions against their income. For example, if a contributor's tax rate is 40%, every $100 he or she invests in an RRSP will save that person $40 in taxes, up to his or her contribution limit. Second, the growth of RRSP investments is tax-sheltered. Unlike with non-RRSP investments, returns are exempt from any capital gains tax, dividend tax or income tax. This means that investments under RRSPs compound at a pre-tax rate.
In effect, RRSP contributors delay the payment of taxes until retirement, when their marginal tax rate will be lower than during their working years. The government of Canada has provided this tax deferral to Canadians to encourage saving for retirement, which will help the population rely less on the Canadian Pension Plan to fund retirement.
There are a number of RRSP types, but generally, they are set up by one or two associated people (usually individuals or spouses).
- An Individual RRSP it set up by a single person who is both the account holder and the contributor.
- A Spousal RRSP provides benefits for a single spouse and also a tax benefit for both spouses. A high-earner (spousal contributor) may contribute to a Spousal RRSP in their spouse's name (the account holder). Since retirement income is divided evenly, each spouse can benefit from a lower marginal tax rate.
- A Group RRSP is set up by an employer for employees and is funded with payroll deductions, much like a 401(k) plan in the U.S. It is administered by an investment manager and affords contributors the advantage of immediate tax savings.
- A Pooled RRSP is an option created for small business employees and employers, as well as the self-employed.
Several types of investment and investment accounts are permitted in RRSPs. They include:
- Mutual funds
- Exchange-traded funds
- Savings accounts
- Mortgage loans
- Income trusts
- Guaranteed investment certificates
- Foreign currency
- Labor-sponsored funds
Contribution and Withdrawal
The RRSP contribution limit for 2020 is 18% of the earned income an individual has reported on their 2019 tax return, up to a maximum of $27,230, according to the Canada Revenue Agency. It is possible to contribute more, but additional sums over $2,000 will be hit with penalties.
An RRSP account holder may withdraw money or investments at any age. Any sum is included as taxable income in the year of the withdrawal—unless the money is used to buy or build a home or for education (with some conditions).
Registered Retirement Income Funds (RRIFs)
In the year an RRSP holder turns 71, the RRSP balance must be liquidated or shifted to a Registered Retirement Income Fund (RRIF) or to an annuity. An RRIF is a retirement fund similar to an annuity contract that pays out income to a beneficiary or a number of beneficiaries.
Money withdrawn from an RRSP through RRIF account payouts is taxed at the account holder's marginal tax rate. If the account holder has $300,000 saved for retirement and is 65 years old, the RRIF will pay about $1,000 per month. If this $1,000 is the only source of income, the account holder will be taxed at a marginal rate of 15%, leaving about $850 every month. The account holder may also receive a monthly Canada Pension Plan.
Registered Retirement Savings Plan vs. 401(k)s
Despite their basic similarities, RRSPs and 401(k)s have differences too.
- RRSPs may be set up via a financial institution; 401(k)s are set up by employers.
- RRSP contribution limits may be carried forward.
- RRSP contributions may come from payroll deductions or cash contributions (which may lead to a tax rebate); 401(k)s are funded with payroll deductions.
- 401(k)s have early withdrawal penalties (though there are exceptions); RRSPs do not.