What Is An RRSP?

When we are young, footloose  and fancy free, thinking about retirement is the last thing on our minds! Unfortunately retirement planning is a reality and it’s better to be proactive and start early. The government encourages everyone to save for their later years by giving them tax incentives.

Every year Canadians are bombarded by our employers and banks to contribute to our Registered Retirement Savings Plans (RRSPs), but many of us don’t really understand them. As you will see below, the sooner we know how these plans work and start contributing, the better off we will be in our later years! So what is an RRSP? An RRSP is a type of account that is registered with the Canadian Government. There are different types of RRSP accounts, these are:

Self Directed (or managed) Investment RRSP
Guaranteed Income Certificate (GIC) RRSP
RRSP Savings Deposit Account

The first allows for investment in stocks, bonds or other securities by yourself or with a broker, the second allows the purchase of GICs and lastly a deposit account simply pays the account holder regular interest on cash. These accounts allow us to defer paying taxes on the funds contributed to them and any interest or capital accumulated. Any funds contributed to the account will reduce a person’s taxable income which will result in a tax refund. For example:

Contributing

Silvia’s income for the year is $75,000 (33% marginal tax rate, Ontario resident) and she pays $16,789 in taxes. She decides to contribute $5,000 to a self directed RRSP to invest in the stock market. This contribution reduces her income for the year to $70,000. When she files her taxes she notes the $5,000 contribution which will result in a tax refund of approximately $1,816. Now this $5,000 can be put to work and earn Silvia money tax free until age 71.

Withdrawing

After age 71, RRSP holders must start withdrawing funds from their accounts (and start paying taxes on it) or purchase an annuity (this is a topic for another post). The government needs to get their money somehow! However, by this time most people are retired and are in a very low tax bracket. At 71, Sylvia has a modest pension income of $20,000 per year which puts her in the 20% marginal tax bracket. Now when she withdraws funds from her RRSP she is being taxed at 20% instead of the 33% she would have paid while she was working. This is a big difference and it only increases if you make more than $75,000 per year.

Other Information

The deadline for contributions to these accounts is February 29th and the annual contribution maximum for 2012 is $22,970.

In future posts I’ll discuss contribution strategies, early withdrawal options, pension contributions, which RRSP account is right for you and more.

The tax calculators I used for this post are from E&Y and Intuit.