The ABCs of RRSPs

A trend toward older people continuing to work beyond the traditional retirement age of 65 – either because they feel motivated and healthy enough to keep at it, or because they worry their savings won’t be adequate – suggests the mandatory RRSP culmination at the end of the year in which you turn 71 might be premature. However, the tax deferral continues after an RRSP is terminated if the balance is transferred into a registered retirement income fund (RRIF) and/or a life annuity, with amounts being taxed only when funds are withdrawn. The only catch is that, once the transfer has taken place, you gradually must begin taking income from an RRIF or annuity. In the case of a RRIF, the minimum annual withdrawal amounts increase over time.

Annual RRSP Contribution Limits

The maximum annual contribution to an RRSP is 18% of your earned income in the previous taxation year, up to a dollar limit which is set each year. (“Earned income” for the most part is your personal work income from employment or self-employment, as well as net real estate-rental income, CPP/QPP disability benefits, and any taxable alimony received.) For 2023, the dollar cap is $30,780, and for 2024 it’s $31,560. To contribute the maximum in 2023, your 2022 earned income must have been more than $171,000; for 2024, your 2023 earned income must be at least $175,333.

If you are a member of an employer pension plan, a pension adjustment (equal roughly to the amount you put into that plan during the year) will reduce the amount of your RRSP contribution.

If you contribute less than your maximum amount in any one year, that amount is carried forward for use in any future year. This is known as RRSP contribution room. Fortunately, you can find out where you stand in terms of your annual RRSP limit and overall contribution room by checking the Notice of Assessment you received after you filed last year’s income tax return.

The amount you actually contribute for a year is tax-deductible, which means the entire amount in your RRSP grows on a tax-deferred basis. When money is eventually withdrawn, you pay tax on that amount (both capital and income) – in theory at a lower tax rate than had you made the withdrawal in a higher income, working year.

The deadline for making a contribution for 2023 purposes is Thursday, February 29, 2024. Normally the deadline is March 1, but because this is a leap year and the rules specify a tax-deductible contribution can be made up to 60 days into the following calendar year, the actual date is the last day of February. In years when the deadline falls on a weekend, the deadline is moved back to the following Monday.

RRSP Contribution Strategies

Generally speaking, it is usually best to make full use of your RRSP contribution room. This ensures you have the highest amount of retirement savings growing on a tax-deferred basis. However, in a low-income year (such as if you took a leave from work), then you might be better off waiting until the following year when your income would return to its former level, thus making the tax deduction more valuable. Of course, your contribution limit for that low-income year would be reduced due to the 18% earned-income restriction.

The Best Types of RRSP Investments

Based on tax rates alone, fixed-income investments such as bonds and cash deposits would seem best placed within an RRSP, as opposed to equity investments. This is because interest income is fully taxable, whereas dividends and capital gains receive tax breaks. For example, an Ontario taxpayer with $120,000 of taxable income in either 2023 or 2024 would pay tax at 43.4% on interest income, compared with 25.4% on dividends fully eligible for the dividend tax credit and 21.7% on capital gains. In Quebec, the same taxpayer would pay tax at 45.7%, 29.6% and 22.9% respectively, with similar discrepancies in other provinces.

However, the decision is best not based on tax efficiency alone. An RRSP will likely require equities to achieve your retirement income goals. Moreover, these investments will benefit enormously from the RRSP’s long-term tax deferral, with gains compounding tax-free within the plan until the money is eventually withdrawn from the plan.

Note that dividends paid by foreign stocks do not qualify for the Canadian dividend tax credit and thus should wherever possible be held within an RRSP or other tax-advantaged plan.

RRSP or TFSA?

Ideally, you should make maximum use of both these savings plans. If that isn’t always viable, as a general rule those with taxable income of more than around $60,000 will do well to invest in an RRSP. This is because the money you put in is tax deductible and your deductions go towards reducing what you owe. For those with lower income, the deduction is less valuable, because after claiming basic tax credits, you aren’t likely to owe much income tax. In such a case, putting your money into a TFSA may make more sense.

Your RRSP money is earmarked for your retirement. In theory, when you withdraw these savings at that stage of life, you will be earning less and will find yourself in a lower tax bracket. The expected result is you will pay less overall tax in your lifetime. However, this won’t help you with short- or medium-term goals – such as saving to buy a car or maintaining an emergency fund – in which case a TFSA is generally a better choice, given that you can make withdrawals tax-free and with no penalties.

Early Withdrawals From an RRSP

An RRSP is intended to help you save over the long term for retirement. However, there are no restrictions on withdrawing from it at any time. Barring an emergency that might prompt quick access to RRSP savings, it is preferable only to make a withdrawal if the tax hit might be less than likely will be the case after retirement. Thus, under the right circumstances, it can be beneficial to use an RRSP as a tax-averaging tool. Typically, this could be the case in a year in which your income is lower than what you anticipate it will be post-retirement. Later in your working life, it could make sense to take advantage of a lower tax rate in your pre-retirement years if you work only part-time as a consultant, as part of a career wind-down ahead of actual retirement.

Withdrawals from your RRSP (pre- and post-retirement) are always fully taxable at your marginal tax rate, regardless of the types of investments held within the plan. The entire amount is subject to tax (both original capital and income). The financial institution holding your account will deduct tax at source on withdrawals, remitting the following to the Canada Revenue Agency:

• Amounts up to $5,000: 10% withheld, and;
• $5,000 to $15,000, 20%;
• Over $15,000, 30%.
  
  

For Quebec residents, a single RRSP withdrawal is subject to one-half of the federal withholding, plus a 15% withheld for remittance to Revenu Québec, regardless of the amount withdrawn. So, for a withdrawal of $10,000, 10% federal tax would be deducted at source and 15% provincially.

Tax Deferral Continues Inside a RRIF

When converting an RRSP to a RRIF or to a registered annuity, no tax is payable until the money is withdrawn from the RRIF or annuity. And an RRSP or RRIF rolled over to your spouse’s RRSP or RRIF upon your death is also not immediately taxable. The tax would be paid on eventual withdrawals of that money from the spouse’s account.