Investing in an RRSP. I must admit that when my girlfriends tell me they “invest in an RRSP” it drives me up the wall. I think because they don’t realize that an RRSP is just a holding vault for the investments inside the RRSP but they just blanket-statement say that they already ‘invest in an RRSP’ (but don’t know what the composition is within the RRSP, e.g. mutual funds, ETFs, bonds, US paying dividend stocks etc.).
Registered Retirement Savings Plans (RRSP) is actually a basket of investments that are invested before income taxes but will be taxed when you take the money out of it. The RRSP is a tax deferral strategy. You take money out of the RRSP when your income is low (e.g. in retirement years).
With pre-tax dollars, that means that when you invest in an RRSP you get a tax refund back at your marginal rate for the amount you contributed. In an RRSP, the money you earn in it will also be free of taxes as long as you don’t take it out of the RRSP. Finally, it works as a tax shelter and a way for you to defer your taxes. When you withdraw from the RRSP then you will pay taxes, but the hope is that when you withdraw, your income will be low because you’ll be retired, so you will pay fewer taxes.
How Much Can You Contribute
With an RRSP, you can contribute up to 18% of your earned income, up to a maximum of around $25,000 or so per year. For the most recent rates and contribution maximum, check out the Canada Revenue Agency site. If you are part of a defined benefit pension, your RRSP contribution is affected by the pension adjustment. If you are part of a defined contribution plan your RRSP contribution amount is also affected. You won’t be able to contribute the maximum.
For an easy answer, It tells you on your Notice of Assessment each year (you know that letter you receive from the Canada Revenue Agency after you file your taxes) how much you are allowed to contribute to your RRSP. To check your latest Notice of Assessment (if you lost your physical copy for example) you can go to CRA My Account for Individuals.
The deadline for contribution is March 1 of the calendar year. The first 60 days of the current year can be used for the previous year’s taxes. It’s best to contribute earlier so that you can take advantage of the tax shelter for the year.
Of course, you have to be careful if you over contribute. If you over contribute by more than $2000, you will have to pay taxes on the over contribution. It is 1% per month on the excess amounts (similar to TFSA over-contribution).
What You Can Do With Your Contribution
You can use your contribution to pay less tax. If you know that you’ll be having more income in future years, you can also carry forward your contribution to next year so that you can use it as a deduction. All the meantime, you continue to be investing in an RRSP.
For example, let’s say you are in school for your MBA and only working part-time. While you can still contribute to your RRSP, it makes sense to use that RRSP deduction for when you are working full-time again at that six-figure job fresh out of MBA school, instead of while you are not earning very much. Remember you get a refund based on your marginal tax rate and the higher your marginal tax rate the more bang for your RRSP buck you’ll get.
You can buy US Dollar stocks within the RRSP, and in fact, this is usually the best place for dividend-paying USD equities because of the shelter from taxes on your USD investments.
Just like with other registered accounts like the TFSA, you can hold different types of investments in an RRSP (GIC’s, mutual funds, bonds, exchange-traded funds, equities etc.).
How You Can Use your RRSP
Other than saving for retirement, the RRSP is flexible in that if you need to take money out of your RRSP’s for purchasing a home or if you decide to go back to school, you can.
Home Buyer’s Plan (HBP)
- you can borrow $25,000 from your RRSP to pay for building or buying your first home, I know it’s not very much considering the cost of housing is ridiculous right now in Canada, but it’s better than nothing! And how many avocado toasts did you sacrifice to save up this $25,000? 🙂
- You have to be a first time home buyer (did not occupy a home you own for the past four years)
- You also have to live in the home you built or you live in for one year after withdrawing funds from your HBP
- After the first year, you are required to pay back the amount you borrowed in the second year of owning your home, the minimum amount is 1/15 of the amount you borrowed.
- You have to pay it back within 15 years
Life Long Learning Plan (LLP)
- You can also withdraw or borrow $20,000 from your RRSP to fund yourself or your spouse or common-law partner’s education
- To be eligible for the Life Long Learning Plan, it has to be full-time enrolment
- Enrolment has to be done before March of the following year
- You have to pay it back within 10 years, at 1/10 of the amount you borrowed at minimum
- You can use the Life Long Learning Plan over and over again as long as you pay back completely the balance owed to your RRSP
In addition, you can use your RRSP to lower your net household income so you can qualify for increased Canada Child Benefit, which is a monthly ‘supplement’ that the government of Canada provides for young children under the age of 6.
Related: Child Tax Benefit Payment Dates
What Happens if You Take Money out of the RRSP Before you Retire?
If you take money out of the RRSP before you retire, you will have to pay a withholding tax AND you will have to pay the tax according to your marginal rate for that year (of course, if you’re low income that’s okay).
If you withdraw more than $15,000 you will have to pay a withholding tax of 30%. Ouch! If it’s $5000 to $15000, it’s 20% and if it’s under $5000, it’s 10%.
This harsh penalty for taking money out of the RRSP encourages Canadians to save for retirement and not touch their RRSP money. Instead, they encourage you to keep investing in an RRSP.
What Happens When you Turn 71
71 is sure a long way from now so it’s definitely difficult to think about for us millennials. Current laws in Canada state that when you turn 71, you have to turn your RRSP into an RRIF (Registered Retirement Income Fund).
Instead of putting money into the RRSP, you will now withdraw money with an RRIF.
Readers, are you a fan of investing in an RRSP or do you prefer the TFSA?
What do you do when you are investing in an RRSP?
GYM is a 30 something millennial interested in achieving financial freedom through disciplined saving, dividend and ETF investing, and living a minimalist lifestyle. Before you go, check out my recommendations page of financial tools I use to save and invest money. Don’t forget to subscribe for blog updates, a free dividend yield spreadsheet, and the free Young Money Bootcamp eCourse.