It is once again the time of year when advertisements for Registered Retirement Savings Plans (RRSPs) can be found everywhere. As a result of all this coverage, most people have heard about RRSPs. Unfortunately, far too many people are not sure about how they work or what they are intended for.
RRSPs are not one particular type of product or investment, but instead can take the form of any number of financial products or investments. The significance of RRSPs is how they are treated from a tax perspective once they are placed under the RRSP “umbrella”. Basically three things happen.
First, any money that’s contributed to an RRSP is tax deductible. For example, if someone made $60,000 in salary income and they contributed $10,000 to an RRSP, then for tax purposes Canada Revenue Agency (CRA) would say that they made only $50,000. Assuming one’s employer withheld exactly the right amount of taxes for $60,000 of income, then that individual would get a tax refund of $2,970.
The second thing that happens with RRSPs is that the investments are allowed to grow on a tax deferred basis. This means that the CRA does not take its portion of the gains from the investments every year. Most investments do not have this advantage and the difference between a tax deferred investment and a regular investment can be quite substantial, especially over longer periods of time.
The third thing that happens with RRSPs, is that in most cases when money is withdrawn it is fully taxed. An individual can even end up paying more in taxes when they take money out of an RRSP than the deduction they received when they put it in. The whole idea behind an RRSP is that one contributes to it when they are making an employment income, and then they take it out when they retire and are earning less. Two exceptions to this rule are the Home Buyers Plan and the Lifelong Learning Plan.
The amount of money one can contribute to an RRSP is not unlimited. An individual can contribute a maximum of 18% of their gross income up to a recently increased limit of $22,000 for 2010. If one did not use their full limit in previous years, this amount automatically is carried forward indefinitely. Conversely, if one put money into an RRSP then immediately took it out, they would lose this contribution room. In most cases, RRSPs should be long term accumulation vehicles used for retirement planning.
An individual’s RRSP allocations should be determined by their particular goals, personal circumstances, investment knowledge and risk profile. RRSPs are a great financial planning tool and likely belong in most individuals’ tool box for building financial independence. One should ensure this planning is carefully executed because the difference of a couple percentage points in rate of return can make the difference between retiring in style and barely getting by.
P.S. The deadline for contributing to one’s RRSP this year is March 1st .
Troy Peart B.B.A., CFP, CFA can be emailed at firstname.lastname@example.org. Your questions, comments or suggestions for future articles are encouraged.