RRSP 101: What you need to know to use it to your advantage
I like to think about RRSP as one of the ways of allocating assets. Other ways to allocate assets could be: to keep cash on hand, to keep money in a chequing account at a bank to cover day-to-day needs, to buy an asset (such as a house) and many others.
Think of them as containers to put your money into. Each of these containers has its own benefits and disadvantages. Some containers are fixed or limited in size and some are not. They are treated differently from the tax prospective. Some allow flexibility to take money back and reallocate to other containers, some do not. The goal of a financial plan is to figure out how much of your assets needs to go in each container at a certain time throughout your life to help you achieve your life goals.
So, RRSP, or Registered Retirement Savings Plan. It is “Registered” in the sense that the Canada Revenue Agency (CRA) keeps tabs on how much of this container you use and how much space you have left in it. It is a “Savings Plan”, meaning that the primary goal of putting assets in this container is not to try and get them back soon after. It is aimed at providing “Retirement” supplement to other sources of income you may have when you are retired. Within the RRSP container there are different ways of investing: from low-risk fixed interest savings deposit to various stock market investment strategies.
Let’s talk about the size of the RRSP container (also known as “RRSP room”). An opportunity to use RRSP to keep your assets in is given to any Canadian under 71 years old who is earning employment income. The room accumulates at 18% of this income, up to a certain amount (“RRSP dollar limit”) per year. This amount is determined by the CRA and is $27,830 for 2021. Your personal RRSP room is known to the CRA and you can find it in your personal account available on the CRA website, or from your Notice of Assessment.
Now, why all this supervision from the CRA’s side on how much RRSP room you have? This has to do with the benefit available for each dollar you put in the RRSP container — delaying your taxes. If you decide to allocate your after-tax assets to RRSP, you can (but do not have to) ask CRA to reduce the amount of tax you pay in that year. In return, you will pay tax when you withdraw the assets after your retirement.
Where is the benefit in that? It all has to do with the progressive taxation system in Canada. If you plan (and happy to) see your total income reduced in retirement, you might recover more money from CRA now than you would have to pay in the future. Of course, this is not necessarily the benefit that you may be able to use if you plan for your retirement income to be higher that what you are earning now.
Of course, there is a trade-off. The assets allocated to RRSP are meant to stay there until you retire. Although not impossible, the withdrawal of assets from RRSP before then attracts a hefty penalty and results in the permanent loss of your contribution room for the amount of withdrawal. The only two reason to take money out of RRSP before retirement without penalties and room reduction is for the purposes of buying your first home or to pay for your or your spouse’s (partner’s) education. Even then, the money taken from the RRSP needs to be returned within 10 years to avoid penalties.
Because of the progressive taxation, the benefit of claiming the RRSP deduction on your tax return is more significant in the year when your income is higher. The good thing is that you are not required to claim the RRSP deduction in the year of investment. You can carry it over to the future years if you expect your income to go up into a tax bracket with a higher tax rate.
The purpose of RRSP is to create a tax efficiency by leveraging lower tax rate at withdrawal. It does not fully eliminate tax on interest, earnings and capital gains the way TFSA does. It makes sense to keep lower growth elements of your investment strategy (such as CIG, bonds or bond ETFs) in RRSP while keeping higher growth elements (stocks and stock ETFs) in TFSA where the higher returns will be sheltered from tax entirely.
Another tax consideration, less evident than the personal income tax, is the withholding tax of minimum 15% on dividends paid by the US or foreign corporations. This tax is deducted for Canadian residents before the dividends are paid (hence, withholding). Directly owned US/foreign stocks and ETFs within RRSP are exempt from this withholding tax. It makes it more tax efficient, therefore, to hold US/foreign stocks or ETFs in RRSP rather than other types of investment vehicles. This exemption does not include Canadian ETFs containing US/foreign stocks.
It should be noted that the intention of RRSP is the long-term accumulation of funds. This is why day trading within RRSP is not allowed and is not tax sheltered.
You can always find your available RRSP contribution room (a.k.a. RRSP deduction limit) on your Notice of Assessment from CRA. If you don’t receive the paper document from CRA (good for you!), this information is still accessible in My Account with CRA. To obtain your latest RRSP deduction limit from the CRA website, follow these steps:
1) Go to https://www.canada.ca/en/revenue-agency/services/e-services/e-services-individuals/account-individuals.html
2) Log in using one of the three options available for the login (if you have never accessed your My Account with CRA, you may need to register first)
3) If you are looking for a quick one number answer, your RRSP limit is shown on the home page of My Account.
4) If you are looking for details, click through to RRSP details and the calculation of the current year’s RRSP deduction limit.
Disclaimer: I am not a certified financial planner and this article does not constitute financial advice. Please do your own research before acting on the material of this article.