You may have heard about a special savings plan that helps Canadians save for their retirement. The name of this plan is a Registered Retirement Savings Plan. It is a popular tool among Canadian consumers.
You know personal loan meaning and other financial basics, but are you willing to understand how RRSP works? In this article, we will talk more about the basics of RRSP investing and why these contributions may become an essential savings tool.
The Definition of an RRSP
What is an RRSP? A Registered Retirement Savings Plan is a special retirement savings plan established by a person who aims to save for their retirement. It should be registered later. The person contributes to this account alone or with their common-law partner or spouse.
The income that is earned in this savings plan will be exempt from tax, provided that the money remains in the plan. When a person obtains payments from the plan, tax needs to be paid.
According to Statistics Canada, the average RRSP contribution increased in all Canadian provinces and territories in 2020, except in Newfoundland and Labrador. Over 6.2 million Canadian consumers saved $50.1 billion for their retirement in 2020.
They did it by making contributions to their RRSP. The number of contributors went up by 4.9%, while the contributions increased by 13.1% in 2020.
The Binder Analogy
An RRSP account is similar to a binder. In this analogy, every piece of paper in the binder accounts for various investment options. Unlike a regular bank account, a person may put any kind of investment into his or her RRSP.
These types of investments may include GICs, ETFs, bonds, stocks, and mutual funds. This binder analogy helps to explain what kind of protection you can receive from RRSPs.
The RRSP protects your investments similarly to the binder cover that protects paper until you wish to take it out. The contributions you make to your RRSP can lower your income taxes, as they are tax deductible. No taxes should be paid until the person withdraws a sum. Hence, your retirement savings may grow quickly over time.
How Much Can You Contribute to your RRSP?
It is an important question as there are certain limitations. A person may contribute the lower of:
- The maximum contribution sum for the tax year, or
- 18% of their income in the past year.
Your RRSP contribution limits can be checked in the CRA MyAccount. You will also find information about Notice or Assessment and your TFSA contribution room there. Notice of Assessment will be obtained after a person files their tax return.
Reasons to Use RRSP to Save for Retirement
The following infographic shows the proportion of contributors among tax filers and average RRSP contributions from 2000 to 2020. As we can see, the proportion of RRSP contributors among tax filers was 29.1% in 2000, while the median RRSP contribution was $2,700. In 2020, the median RRSP contribution was $3,600, and the proportion of RRSP contributors among tax filers was 22.3%.
There are many reasons for using an RRSP to save for your comfortable retirement. Here are the main advantages:
- These savings are tax-free. A great benefit of using an RRSP account is that your savings will expand tax-free as long as you don’t withdraw them. If the funds remain in the plan, any investment earnings or interest a person makes from these funds is not taxed.
- These contributions are tax-deductible. The contributions you make to your RRSP account lower your taxable income. What does it mean? You get a bigger refund and owe less in taxes. Quick tax relief is offered when the RRSP contributions are deducted from the annual income. The contributions are created using pre-tax money.
- Taxes are deferred on your income. A person doesn’t have to pay tax on the money used for RRSP contributions as it is tax-free, provided that he or she doesn’t withdraw the funds from the plan. This rule works for both contributions and investment earnings. Typically, the marginal tax rate of many Canadians with the higher income is lower in retirement compared to contributing years. As a result, a person will probably pay less tax on the money he or she withdraws than they would have paid during their contributing years.
- A spousal RRSP may lower the combined tax burden. Do you make more than your partner or spouse? Then you may help your spouse build their tax-free savings if you contribute to a spousal RRSP. Later, the retirement income will be divided between you. The total amount of tax you need to pay will be lowered.
- RRSP can be converted to obtain regular payments once you retire. Your RRSP savings may be transferred to an annuity or a Registered Retirement Income Fund (RRIF) without paying taxes. It may be done when you retire. Tax should only be paid on the regular payments you obtain every year. Those who are in a lower tax bracket will pay fewer taxes.
- Money from RRSP can be borrowed to purchase a home. It is another benefit of having an RRSP account. You can take out as much as $20,000 to cover your education expenses. This rule works under the Lifelong Learning Plan for the person with an RRSP or spouse. Besides, you may withdraw up to $35,000 for a down payment if you want to purchase your first home. Read more about the Home Buyers’ Plan to understand how it works. Such money borrowing is tax-free, provided the person returns the funds within a certain period.
The Bottom Line
In conclusion, an RRSP account can help you save for your retirement. Every person with earned income who files a tax return has a chance to open this account. There are options to open a group, spousal or individual RRSP. Your savings and investments can be held in your RRSP, and they grow tax-free as long as the funds remain in the plan.