It's a new year, and that means it's RRSP time. But why do we talk about RRSPs at this time of the year? How exactly does an RRSP work and should you have one? In this blog post I'll tell you a bit about what an RRSP is, what they're good for, and when they might not be so beneficial.
What is an RRSP?
RRSP stands for Registered Retirement Savings Plan. Like the name suggests, the idea behind them is that you make contributions while you're working, then take money out to supplement your income once you retire. RRSPs aren't just a savings account, though. You can hold various types of investments in your RRSP account, so (ideally, anyway) your money is making money and your savings are growing, rather than losing value to inflation by just sitting in a savings account. An RRSP isn't intended to be used like a regular savings account, either. It's best to avoid taking money out of your RRSP, so you'll still want a regular savings account with an emergency fund so you can leave the RRSP alone.
The big advantage to RRSPs that most people are familiar with is that you can claim a deduction on your taxes to match your contributions. So if you put $5,000 into your RRSP, you can claim a $5,000 deduction on your tax return. If you're in the 15% tax bracket that equals a savings of $750; or $1,300 if you're in the 26% tax bracket.
That RRSP deduction is why we start talking about RRSPs and tax planning this time of the year. The government allows RRSP contributions up to 60 days after the end of the year to be included on last year's taxes. They do this to give people a chance to do some tax planning and get an idea of what their tax payable is for the year. Then they can decide if they want to reduce their tax payable by contributing to an RRSP and claiming the deduction. It also gives people a chance to figure out where in the tax bracket they're sitting so they can figure out the most beneficial amount to put into their RRSP.
Effect of tax brackets on RRSP deductions
That's the other part that's important to understanding how to make your RRSP work for you: tax brackets. You get to claim a deduction when you put the money in, but you have to pay tax on whatever money you take out of the RRSP. Otherwise, you'd never be taxed on that income. If your income is less than about $54,000 (for the 2023 tax year) you're in the 15% tax bracket. That means when you claim your RRSP deduction, you save 15% of your contribution amount in tax. That's great! But, hang on, when you take the money out after retirement and you're still in that 15% tax bracket, you have to pay 15% on whatever you took out. So what's the point in saving 15% now to pay 15% later? You're just coming out even, right? Well, the idea is that you should put money into an RRSP when you're in a high tax bracket and take the money out when you're in a low tax bracket. That's where the advantage lies. If you put money in when you're in the 26% tax bracket and take money out when you're in the 15% tax bracket, there's 11% of your original contribution that you'll never pay tax on.
RRSP contributions for people in low tax brackets
Okay, so what about people in that lowest 15% tax bracket? And what about people who know their income isn't going to drop into a lower tax bracket when they retire? Should they even bother with RRSPs? It depends. Sometimes your employer will put money into an RRSP for you, usually matching a percentage of your contributions. If your employer is going to give you more money, you should take it! Maybe you've got some great investment and all the money you save by claiming an RRSP deduction is going into that investment and making you more money. You should keep doing that! Maybe you know your taxable income will be so low after retirement that any money you take out of your RRSP will be lower than the basic personal amount and you won't need to pay tax on it anyway. Maybe you just have more expenses now, like mortgage payments or kids in school, and need extra cash you won't need after retirement. Everyone's different, so you need to consider your own situation.
For people who know they're going to be in a higher tax bracket after retirement, but have a spouse/partner who will be in a lower tax bracket than you, a spousal RRSP might work well. A spousal RRSP is a way to transfer money to your spouse/partner so it gets taxed at their lower tax rate when it's withdrawn, while still allowing you to claim the deduction at your higher tax rate when you put the money into the plan. Again, it's important not to treat a spousal RRSP like a regular savings account. If your spouse/partner withdraws money from the spousal RRSP and you made a contribution in that year or either of the two prior calendar years, the money withdrawn gets taxed on your tax return at your tax rate, defeating the whole purpose of transferring it to your lower income spouse.
If you're not sure whether or not an RRSP would be beneficial for you tax-wise, that's something we can help you figure out. For some people a tax free savings account (TFSA) might work better . . . but we can talk about that another day! For now, I hope this gives you a good handle on the RRSP basics.
Thanks for stopping by, and I hope everyone had a great holiday!