Will an RRSP Contribution Work for Me?
2020 marks the 55th anniversary of Canada’s famous tax deferral program – the Registered Retirement Savings Plan – one of the few ways that Canadians can earn an income tax deduction. At the time, an Ottawa area division manger for the Bank of Montreal called it “the greatest vehicle for retirement savings”. But how does this program work, exactly?
- The RRSP works its income tax-reducing magic by essentially reducing the amount of your income that the government can tax (also known as ‘taxable income’). Most people pay their taxes at source – that is, off their paycheques, throughout the year. Accordingly, when Canadians file their taxes, they get to reduce, dollar-for-dollar, their income level by the amount deposited to an RRSP account and defer the tax owing to future years. If a person earned and paid taxes on $100,000 but also put $10,000 into an RRSP account, the Canada Revenue Agency (CRA) would only be entitled to tax on $90,000. Whatever taxes were collected at source on the other $10,000 during 2019 would be refunded after taxes are filed in April 2020.
- The principle works the same in reverse. If a person needed to make a withdrawal from their RRSP to, say, take that dream vacation to Bali, the gross amount of the withdrawal (including the taxes collected and sent to CRA on your behalf) are added to your income for the year – thus cancelling the “deferral” on the gross amount your withdrawal. The gross amount of the withdrawal will also be subject to what is called a withholding tax – 10%, 20% or 30%, depending on the amount of the withdrawal. In many cases, the taxes withheld are not enough to cover the tax due because of the additional income, so further taxes will likely be payable when you do your taxes the following April. Needless to say, this is not the best strategy for vacation planning! And to make matters worse, that contribution room is lost forever.
- There are two exceptions to this rule: 1) The Home Buyers’ Plan: which allows first time home buyers or those who have experienced a recent marriage or common-law partnership breakdown, to withdrawal up to $35,000 from an RRSP without any withholding tax in so long as the money is re-paid to the RRSP within 15 years, and; 2) the relatively new Life-Long Learning Plan – which allows adults to withdraw up to $10,000 per year to a maximum of $20,000, tax free, from your RRSP in order to go back to school. The program gives participants 10 years to repay the funds to their RRSP.
- There are no restrictions on who can deposit money to an RRSP. As long as you are a tax-paying resident of Canada with Canadian earned income and a Social Insurance Number, you are eligible for the benefits of the RRSP program.
- Canadians can contribute up to 18% of their earned income to a maximum of $27,230 in 2020. If you are a member of a Registered Pension Plan (RPP) or Defined Profit Sharing Plan (DPSP), your contribution limit is reduced by the amount contributed by your employer to these plans. The reduction is referred to as a “Pension Adjustment”, or P.A.
- Like all good things, the timeline of tax deferral must also eventually end. In fact, all RRSP funds must either be withdrawn or converted into a Retirement Income Fund (RIF) by the end of the calendar year in which the investor turns 71. The beauty of the RRSP is that tax is eventually paid on the money deposited – but at age 71 and beyond, most of us are paying taxes at a much reduced rate compared to what we were paying at age 31, 41 and 51. Not only have we, as Canadians, benefited from a regular savings plan in order to supplement our pensions, we have reduced the amount of taxes that we pay in the process.
“I have prepared this commentary to give you my thoughts on various investment alternatives and considerations which may be relevant to your portfolio. This commentary reflects my opinions alone and may not reflect the views of Harbourfront Wealth Management. In expressing these opinions, I bring my best judgment and professional experience from the perspective of someone who surveys a broad range of investments. Therefore, this report should be viewed as a reflection of my informed opinions rather than analyses produced by Harbourfront Wealth Management Inc.”
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