The term RRSP stands for Registered Retirement Savings Plan and it is essentially a special kind of savings account. First introduced in 1957, an RRSP is one of the best ways available for Canadian investors to save money for retirement while helping them lower their income tax payments.
How Does an RRSP Work? It’s Actually Quite Simple
The first step is to open an RRSP account with a financial institution, which can usually be done at any bank or brokerage firm. Once the account is open the holder can start putting money in to it right away. The cash inside the plan can be used to buy a wide variety of financial instruments such as GIC’s, mutual funds, stock or bonds. Any interest, dividend or capital gain made inside the account will not be taxed until that money or investment is withdrawn. The purpose being that the investments in the account can grow much faster when they are not being taxed each year. The tax is still eventually owed, but it is deferred until the money is taken out which would normally be at retirement when that person’s yearly income would typically be much lower.
In addition to saving for retirement, putting money in to an RRSP has another great advantage - lowering income tax. Any deposits made to the account (known as contributions) can be deducted from that individual’s taxable income that year. The more money that goes in to the plan, the less income tax will be due at the end of the year.
So what does this mean for the average investor? Think of it this way: If someone makes $50,000 a year they would be responsible for paying taxes based on that amount. But if that same person also contributes $7,000 to an RRSP over the course of the year, when tax time comes they would be treated as if they only earned $43,000 that year ($50,000 - $7,000 = $43,000). This way the investor gets to keep more of their money and pay less tax.
This process can sometimes seem complicated to novice investors so it’s always a good idea to consult a financial advisor. They can explain the finer details and help come up with a good investment strategy.
RRSP Contribution Limits
Saving for retirement is great, but there are limits on how much can be put in to the account from year to year. This limit largely depends on how much someone made the previous year. The more money someone makes, the more they can generally put in to their RRSP. The total amount that can be contributed is found on the Notice of Assessment statement that comes from the federal government each year after someone files their tax return, or on the Canada Revenue Agency web site.
In addition, any unused contributions from previous years can be carried forward to future years. This means that if someone was not able to put away all the money they were permitted to the previous year, the difference can be used the next year, or any other future year.
Self Directed and Spousal (or Common Law) RRSP’s
There are a few different varieties of the traditional RRSP. A self direct plan allows the account holder the flexibility to make his or her own choices about exactly what kind of investments are made inside the account. This can be done alone or with the assistance of an adviser. This can be an exciting and empowering way to plan for the future, but there is also potential for substantial losses. This option is usually best left to those with a great deal of experience in the financial industry.
A spousal (or common law) RRSP works very much like a traditional RRSP, but it allows for one partner to contribute to the other partners account. This is usually done when one person in the relationship earns more income than the other. The higher earner can reduce their yearly income tax by contributing to the lower earners account, and the lower earner benefits by having their account grow faster.
Fees and Restrictions in RRSP’s
When first opening an account, be sure to ask about fee’s and restrictions on the accounts. These can vary greatly depending on what type of investments one chooses and how active their account will be. Not every account will be suitable to hold any kind of investment. There is no limit on the number of RRSP accounts that someone can have, but the contribution limit for each year will be applied across all RRSP accounts, not each one individually.
Also, money put in to an RRSP is really meant for retirement, so although taking money out before that time is possible, it’s generally not a good idea. More details on the subject can be found in the article "Withdrawing from your RRSP before retirement."
An RRSP is an excellent way to plan for the future and every Canadian should strongly consider having one. As always, be sure to consult with a professional financial adviser before making any kind of investment.
Dylan Flanagan - Dylan Flanagan is a freelance writer based in Toronto, Canada. With a diverse range of work and life experience, he now writes on a ...
Join the Conversation