What is RRSP and How Does it Work?

With life expectancy growing worldwide, saving for retirement has become a priority for many Canadians. According to a 2023 survey by the Healthcare of Ontario Pension Plan, half of working Canadians (50%) rank saving for retirement as among their top two financial priorities.

However, given the multitude of retirement savings plans, finding the right one can be daunting. If you’ve been mulling over financing your retirement, then setting up an RRSP investment could be a smart move. 

RRSP is an acronym for Registered Retirement Savings Plan. This describes a retirement plan by the Canadian government that lets you contribute to your retirement savings but with added tax benefits. Keep reading to learn everything you need to know about an RRSP, including how it works and how it can benefit you in the long run. Let’s dive right in.

What Is an RRSP?

As mentioned, RRSP stands for Registered Retirement Savings Plan, a government-backed retirement savings plan for Canadian citizens. You, your spouse, or your non-ceremonial partner can contribute a percentage of your earnings to an RRSP for your retirement. However, what sets an RRSP apart from most retirement plans is that it’s “tax-advantaged.” This means that whatever money you put inside your RRSP account is tax-exempt until you retire. 

How Does an RRSP Work?

As mentioned, an RRSP is a retirement savings plan with added tax perks. Since RRSPs are Tax-exempt, the Canada Revenue Agency (CRA) will not tax the amount you contribute to your RRSP. This not only lowers your yearly taxes but also leaves you with more money during retirement as the money you save grows tax-free. 

To put everything into perspective, let’s say you earn $100,000 a year and decide to contribute 15% of your annual earnings ($15,000) to your RRSP. Normally, the CRA should tax your $100,000 yearly income, but because you contributed $15,000, it will only tax $85,000 ($100,000 – 15,000) of what you earned.

However, it’s worth noting that it doesn’t mean you won’t pay taxes on the $15,000 you saved. You’ll eventually have to pay taxes once you retire, but by the time you do so, you’ll have so much that you won’t even feel the pinch. Plus, being retired puts you in a lower tax bracket, meaning you’ll pay less taxes than you would have in your working years.

Types of RRSP

Now that we’ve covered “how does an RRSP work?” let’s now examine the types of RRSPs. This information will be vital in opening the right type of RRSP account to get the most out of it. There are four types of RRSPs that you can opt for. 

Below is a brief breakdown of all of them:

RRSP vs. Other Saving Accounts

The Canadian government doesn’t bind citizens to RRSPs for their retirement savings. In fact, Canadians are free to pick from a broad range of savings accounts, but most don’t offer the benefits an RRSP account does. Let’s briefly examine how RRSPs compare with other savings accounts in Canada.

RRSP vs. Tax-Free Savings Account (TFSA)

Tax-Free Savings Accounts, or TFSAs, are general savings accounts that let you save for whatever goal minus taxes. You can save for retirement, a new construction project, a car, or your college education with a TFSA. However, as the name implies, TFSAs are tax-free, and you don’t have to pay taxes on withdrawals.

What makes an RRSP different from TFSA is that RRSPs are retirement-centric while TFSAs are general-purpose. The two are also different in their tax approaches. With a TFSA, the CRA taxes the money you contribute to the account but won’t tax you during withdrawal. An RRSP does the opposite and doesn’t deduct income tax on your contribution but will tax your withdrawals.

RRSP vs. Registered Retirement Income Fund (RRIF)

A Registered Retirement Income Fund (RRIF) goes hand-in-hand with an RRSP or other applicable plans. The federal government requires all RRSP members to convert their savings into a form of retirement income by the last date (31st December) of the year they turn 71. An RRIF takes the money you saved in an RRSP or other registered plan and pays you a minimum amount yearly. 

You can hold the money you transfer to an RRIF in an investment vehicle (bonds, mutual funds, etc.) of your choice. However, you cannot contribute anything outside your RRSP savings to the RRIF. The major difference between an RRSP and an RRIF is that the latter pays you a minimum yearly income. Of course, you can withdraw more than the minimum amount, provided it is within the allowable threshold. It’s also worth noting that the minimum annual withdrawals are subject to income tax. However, withdrawals over the minimum amount will be subject to both income and withholding tax.

RRSP vs. Registered Education Savings Plan (RESP)

A Registered Education Savings Plan (RESP) gives Canadians the means to secure their children’s education after high school. It covers everything from college and trade school to apprenticeships and other forms of post-secondary school education. 

This plan lets you contribute to a tax-deferred savings account to finance your children’s education after high school. Like other savings plans, you can invest RESP into various financial assets. However, the best part is that the financial institution can apply for educational benefits, including grants and the Canada Learning Bond (CLB). The beneficiaries can use them to pay for tuition, books, and other educational expenses.

The most obvious difference between an RRSP and an RESP is that an RRSP account is focused on retirement, while an RESP is education-centric. Another difference is that contributions made to a RESP account aren’t tax-deductible, but you can withdraw from the fund tax-free.

RRSP vs. Registered Disability Savings Plan (RDSP)

According to Statistique Canada, approximately 27%  of Canadians aged 15 and above had some form of disability as of 2022. Catering for disabled persons can be expensive, hence the Registered Disability Savings Plan (RDSP). This savings plan contributes to the future of a disabled person. The savings plus government grants will fund their long-term needs, but the fund is only available for eligible disability tax credit applicants.

Investments in the RSDP mature minus tax, provided that the investment stays in the savings plan. The contributions made to an RSDP are tax-deductible, and withdrawals are tax-free. However, benefits like grants, rollovers, and income generated from it are taxable. The RSDP is different from an RRSP in that withdrawals are not taxed in RSDPs, while they are in RRSPs.

Benefits of an RRSP

RRSPs are immensely beneficial for all eligible Canadians, including workers and business owners. Some of the key benefits of this saving plan include:

1. Your Contributions Are Tax-Deductible

You can claim your RRSP contribution as a deductible when filing your tax returns. Given that you can contribute up to 18% of your earnings to an RRSP, you can save a bundle in taxes. What’s more, you can roll over your contributions to a future tax year and accumulate your tax deductions to get even more tax savings.

2. Savings Mature Tax-Free

The contributions in your RRSP mature based on how you choose to invest it. Whatever your investments earn won’t be taxed, provided they remain in your RRSP. This means your investment compounds without the burden of annual taxation, and your savings grow faster with time.

3. You can Buy Your First Home or Pay for School Against Your RRSP

The federal government, via the Home Buyer’s Plan (HBP), lets you use the money in your RRSP account as a down payment for your first home. Contributors can borrow up to $25,000 for this purpose. They can also use as much as $20,000  to cover education costs for you or your spouse through the Lifelong Learning Plan (LLP).

4. Partnering With Your Spouse Can Reduce Your Tax Burden

A spousal RRSP arrangement can help ease the tax burden between you and your significant other. The higher-earning spouse can register an RRSP account under their spouse’s name and only pay high taxes for the first three years of the RRSP. Later, they can split the burden for the remaining years. 

Common Mistakes to Avoid

An RRSP investment could turn left if you don’t understand the terms and conditions or mismanage your account. Some common mistakes to avoid when contributing to an RRSP are:

1. Having a Cash-Only RRSP

Sure, an RRSP is a savings account, but that doesn’t mean you should only put cash in it. A better alternative is to invest the cash in your RRSP into stocks, ETFs, and other financial instruments. That way, your investments can grow tax-free and increase your savings.

2. Contributing More Than What’s Allowed

The federal government only allows you to contribute a maximum of 18% of your earnings to an RRSP. Contributing too much could lead to a 1% monthly penalty on your excess contributions. The CRA allows a buffer of $2,000 in contributions over the lifetime of your RRSP, but anything above this is penalized.

3. Withdrawing Your Savings Too Early

You may be tempted to take a bit of money from your RRSP, but this will likely work to your detriment. For starters, doing so compromises your tax-free investment growth. Plus, money withdrawn from your RRSP counts as taxable income, thus increasing your tax liability for that tax year.

Final Thoughts

Now that you know what is RRSP, you should be able to make more prudent decisions about your retirement savings plan. Investing in an RRSP is a great way to safeguard your future post-retirement. If you’re unsure of how to invest your RRSP, consider hiring a financial advisor to help you pick the best investment vehicles. Lastly, don’t forget that there are plenty of other alternatives to an RRSP, so choose the best one depending on your specific needs. Good luck with your savings and investments!