For well over half a century, registered retirement savings plans have been Canadians’ main vehicle for long-term savings. The main attraction of RRSPs is their long-term tax deferral, which makes it essential to get one started as early as possible in your working life.
However, we often don’t get serious about retirement savings until we’re into our 40s. By this stage – with a higher income and retirement only two or three decades away – the rule of thumb for financial planning is to make your maximum allowable contribution each year. This includes your unused contribution room and the additional amounts added each year to your cumulative limit. Basically, if you don’t use it, you don’t lose it -- until you reach 71.
But there are strategies to consider during those prime contributing years up to around age 60, when retirement draws near and the RRSP may become less of an investment priority, or you may even be ready to begin drawing on your savings.
What Is an RRSP?
An RRSP is a tax-deferral arrangement in which you deduct the amount of contributions on your income tax return and your investment grows free of tax until withdrawals are made. You pay tax on withdrawals at your top marginal rate, which is presumably at a lower rate than during your working years.
A contribution qualifying for a deduction in a particular year can be made no later than 60 days following the end of that year. The annual contribution limit is 18% of your previous year’s earned income, up to an annual dollar limit. For the 2024 taxation year, then, you have until March 3, 2025, to contribute either 18% of your 2023 income or $31,560, whichever is lower. (Note that normally the RRSP deadline is March 1, or 60 days following the end of the previous year, but because that date falls on a Saturday in 2025, the deadline is extended to the following Monday.)
The annual RRSP contribution dollar limit is increased each year based on the inflation rate; for 2025, the cap will be $32,490. Unused RRSP contributions can be carried forward to future years, thus building contribution room that can be accessed when you have the available funds or can better benefit from the tax deduction.
What Happens at Age 71 with an RRSP?
An RRSP must be converted to a registered retirement income fund or a registered annuity by the end of the year in which you turn 71. Your savings remain invested in the RRIF or annuity and taxed as you make withdrawals.
The primary goal for RRSP investors is to save as much money for retirement as possible, aided by the tax deferral. However, there are two elements to keep in mind as you consider how much to contribute to your RRSP each year:
- Will your tax rate actually be lower after you retire than it is now?
- Will you be better off using the tax deduction in a later year?
Making maximum RRSP contributions might not be the best route if you expect to have amassed a considerable investment portfolio (both within and outside an RRSP) by the time you retire. For instance, if you anticipate a sizeable inheritance, you won’t necessarily be paying tax on your future RRSP withdrawals at a lower rate than had you invested outside the RRSP. Depending on your specific situation, it might make sense to instead invest outside an RRSP and pay tax on the resulting interest, dividends, and/or capital gains each year, since the latter two types of income are taxable at preferential rates.
In such cases, an RRSP might not necessarily be your best after-tax route. For one thing, capital losses will not be recognized, and dividends and capital gains will be taxed at full rates when you withdraw from your plan.
What Kind of Investments Should I Hold in an RRSP?
However, the long-term tax deferral still may make it worthwhile to hold capital and dividend-paying investments in an RRSP.
Married or common-law individuals should consider the benefits of creating two streams of post-retirement income (income splitting) through a spousal RRSP. Typically, the higher-income spouse contributes to their partner's RRSP and claims the deduction on their own tax return. The goal is to end up with two relatively equal retirement nest eggs that will be taxed at lower rates as money is withdrawn through each spouse’s RRIF.
For more: https://www.morningstar.ca/ca/news/185822/spousal-rrsps-help-couples-save-by-sharing-.aspx
Regardless of your expected future income, it makes sense to make full use of a tax-free savings account. You can invest up to $7,000 in a TFSA for 2024, and you can save unused contributions for the future. The annual limits are increased in future years, indexed to inflation. While you cannot deduct TFSA contributions, no tax is payable (on the income or original capital) when you take money out. What’s more, the amounts equivalent to these withdrawals are restored to your overall TFSA contribution room in the year following the withdrawal.
If you are a member of an employer-sponsored defined-contribution (or money-purchase) pension plan, you may want to consider this before an RRSP. This will depend on the limitations of the plan, but generally one should take advantage of such plans if your employer matches your contributions. Moreover, an employer pension may be charged lower fees by its investment advisor than what you pay for your RRSP.
When Should I Avoid an RRSP?
If your taxable income is less than what you anticipate making in a future year, it may be worth foregoing an RRSP contribution and paying tax now at a relatively low rate on the income that otherwise would have been sheltered by the deduction. You will also benefit from lower tax rates on dividends and capital gains. Your tax bill now may well be lower than what you would pay had you put that money into an RRSP and had it fully taxed later at a potentially higher tax rate. However, you should do the math to determine if you are in a high enough tax bracket to come out ahead over the long run from making the RRSP contribution and claiming the resulting deduction.
Another reason to not contribute for a given year is one of practicality: You can’t afford it. Particularly in years when your children are expensive due to sports or arts activities, and later post-secondary education, retirement savings might not be your immediate priority. Remember, unused RRSP contribution amounts are carried forward for use in a future year.
Delaying the RRSP Deduction
You are allowed to make your maximum contribution but delay the use of the corresponding deduction to a future, higher-income year. So even if you can afford to make a healthy RRSP contribution, it may be to your fiscal advantage to hold off. The money you contribute will still grow tax-free in your plan, and you can later claim the deduction for the contribution when it is more tax-wise to do so.
In some cases, at this career stage, you might have the opportunity to work in the United States or abroad. While you are unable to make RRSP contributions during a year when you are not a Canadian resident (defined by where you live as of Dec. 31), you can maintain your account with a Canadian financial institution. However, if you anticipate being a non-resident for an extended period, from a tax perspective, winding down the RRSP could be beneficial. The Canada Revenue Agency charges a flat withholding tax, which could end up being lower than the tax you might pay on RRIF withdrawals after retirement when you are back in Canada.
