What is an RRSP?

What is an RRSP?

The RRSP, also known as the Registered Retirement Savings Plan, is the primary retirement savings account for Canadians. The main benefit of the RRSP is the ability to defer income tax and grown investments tax free as a way of saving for retirement. In other words, money you put in today is not taxed, it grows tax free, and you only have to pay that tax when you withdraw.

 

RRSP Deposit chart

 

Just like the TFSA, an RRSP is not an investment. It is rather, a type of account that can be used to hold different types of investments. It is not uncommon for people to believe that the RRSP itself is an investment, as they are unaware of what they are invested in within the RRSP. You can hold a variety of different investments inside an RRSP.

An RRSP works in a very simple way. That is, for every dollar you contribute to your RRSP in a given year, you get to reduce your taxable income when filing your taxes. Meaning, if you put $10,000 into your RRSP, the Government will consider you to have earned $10,000 less. This means that you will effectively be saving the taxes you would have had to pay if that $10,000 was included as income. Now it works the opposite way as well. For every dollar you withdraw from your RRSP in a given year, that money is added to your taxable income and you will have to pay additional tax.

 

Chart showing RRSP

 

 

So how much will you save by contributing to an RRSP? Well that depends on how much you earn, and how much you contribute. You know how you always hear that the rich get the biggest tax breaks? Well that is primarily because of how marginal tax brackets and all other tax deductions work.

 

Let’s look at an example. If you lived in B.C in 2020 and had an income of $100,000 your marginal tax bracket would be 38.29%. What this means, is on the next $1 of income, you would have to pay 38.29% in tax. It also means, that for every $1 you contribute to your RRSP, you will save 38.29%. Now if you had an income of $50,000 your marginal tax bracket would be 28.20%. Meaning the next dollar you make is taxed at 28.20% and any tax deductions save you 28.20%. The person with a higher income will actually save more with a $10,000 contribution due to their higher marginal tax bracket. This is why it seems like the rich get the biggest tax breaks.

 

Showing how an RRSP works

 

Now let’s look at the details of how the RRSP contribution works for someone who makes $110,000 in B.C in 2020. If they were an employee and tax was deducted from their pay cheque appropriately, they would have already paid $29,204 in taxes. If this individual makes a $5,000 contribution to their RRSP in the year, the CRA views them as only having earned $105,000. Since they are only taxed on $105,000 rather than $110,000 they would only owe $27,289 in taxes. When they file their taxes, the CRA calculates the difference between what they paid in the year and what they owe after filing taxes. The difference is why you get a refund or have a balance owing each year. This individual would have paid $29,204, but only owed $27,289 meaning they would get a refund of $1,915. The $1,915 is 38.29% of the $5,000 they contributed to their RRSP, which is equal to their marginal tax bracket.

 

The exact opposite of this situation is true as well. If we assume the individual made $110,000 in B.C in 2020, and they actually withdraw $5,000 from their RRSP it gets added to their taxable income. They have already paid the $29,204 they owe in tax from their employment income, but they haven’t paid on their $5,000 RRSP withdrawal. When they file their taxes the government adds the $5,000 RRSP withdrawal to their income, and it turns out they owed $31,119. Meaning this individual owes $31,119 minus $29,204 equals $19,15. The $1,915 they owe is equal to their marginal tax bracket of 38.29% times their RRSP withdrawal of $5,000.

 

Now that you have a better idea of how an RRSP works, what’s the point of it? Well the entire point of an RRSP is to deposit money when you are working and in a high marginal tax bracket. You get a tax savings today, that is ideally reinvested. You then invest and grow the money inside the RRSP tax free. Eventually when you retire, at a lower tax bracket, you withdraw the money and pay a lower amount of tax than you saved when you contributed.

 

 

You hear many people talking about how the RRSP is bad nowadays, and to be frank they are completely wrong. The RRSP is bad, if you use it incorrectly. If I give you a chainsaw and you try to hammer a nail in with it, does that make the chainsaw a bad tool? Or does it perhaps mean you have been using it incorrectly?

 

You see, a lot of people use the RRSP wrong. I’ll give you some situations that I see consistently:

 

  1. They deposit to an RRSP and then don’t reinvest the tax refund. They spend it. This means when they have to pay back the tax when they withdraw, they have already spent that money rather than saving it.
  2. They deposit to an RRSP and then withdraw it before retirement. The RRSP’s primary benefit is to deposit when you are in a high marginal tax bracket and withdraw when you are in a low marginal tax bracket. If you deposit in a lower tax bracket and withdrawal in a higher tax bracket, it works against you. This is very common as a lot of people will contribute when they are in their 20’s and 30’s then withdraw in their 40’s and 50’s when they are making significantly more money.
  3. They don’t properly invest the money deposited to the RRSP. It get’s kept in cash, GIC’s or other very low risk investments. For most people they contribute at a 30% tax bracket, barely grow the money, then withdraw at 30%. It provides extremely little benefit for people in this situation. I’m not advocating to avoid low risk investments, but you have to have a strategy for making the RRSP work for you.

With each of these examples, the primary problem is a lack of understanding. The individual doesn’t have a plan in place on how to use the RRSP effectively. The RRSP will be most effective for those who understand its purpose and use it appropriately.

 

Now everyone has a limit to how much they can contribute to their RRSP. This contribution room increases and carries over every year. It increases by 18% of your earned income, up to a 2020 maximum of $27,230. When I say it carries over, that means if you had $20,000 in RRSP room this year and put $5,000 in, the $15,000 in remaining room would be available for use in the future.