What it means
An RRSP is an account that a person opens with a bank, an insurer or an investment firm. The account can hold different investments, such as funds, shares and bonds.
The tax authority gives it special treatment so that people are encouraged to save for the long term. The main benefit is the tax deduction.
When you contribute, the amount is subtracted from your taxable income, which reduces the tax you owe or increases your refund. If you contribute $10,000 and your marginal tax rate (the rate on your next dollar of income) is 30%, you save $3,000 in tax.
Growth inside the plan is tax-free until it is withdrawn. This means interest, dividends and capital gains build up without being reduced each year by tax, which helps compounding.
When money is later taken out, it is added to income and taxed at the rate that applies at that time. The theory is that you contribute when your income, and tax rate, is high and withdraw in retirement when your income, and tax rate, is lower.
This is why the RRSP is attractive to people in higher tax brackets. For people in a low bracket, the benefit is smaller, and other accounts may be better.
How much you can contribute is limited by contribution room, which is based on a percentage of earned income, up to an annual maximum set by the tax authority, plus any unused room from earlier years. Workplace pension benefits reduce the room through the pension adjustment.
Contributing more than your room can lead to penalties. Withdrawals before retirement are taxed as income, and the contribution room is generally lost.
There are exceptions, such as programmes that let people borrow from their RRSP for a first home or for education, with repayment rules. Finance and HR teams often offer group RRSPs, where contributions come from payroll.
In practice
Real-world examples.
Example
An engineer earning $120,000 contributes $15,000 to her RRSP just before the deadline. At a marginal rate of 40%, her tax bill falls by 15,000 x 0.40 = $6,000. She invests the refund in her mortgage.
Example
A small company offers a group RRSP and matches employee payments up to 3% of salary. An employee earning $60,000 who contributes 3% puts in $1,800 and receives an extra $1,800 from the company. The match is effectively free money for the employee.
Example
A self-employed designer has an uneven income. In a high-earning year, she makes a large RRSP contribution to bring down her taxable income. In a lean year, she contributes little.
Formula
Calculation
Tax saving = RRSP contribution x marginal tax rate
Net cost of contribution = contribution - tax saving
Suppose a manager contributes $10,000 to her RRSP, and her marginal tax rate is 30%. Tax saving = 10,000 x 0.30 = $3,000. Net cost = 10,000 - 3,000 = $7,000. If the money later grows to $40,000 and is withdrawn at a 20% tax rate, the tax is 40,000 x 0.20 = $8,000, leaving $32,000.Case study
Seen in the real world.
Aspen Creek Consulting is an illustrative, fictional firm that offers a group RRSP to its 40 staff. At first, only a quarter of the staff took part, because the sign-up form was long and few people understood the benefit.
The office manager produced a one-page guide with a simple example. A $5,000 contribution by a staff member at a 35% marginal rate cut her tax by 5,000 x 0.35 = $1,750, so the net cost was $3,250.
Participation rose from 25% to 70% over the next year. The illustrative lesson is that the tax saving is the hook, and a clear example is the best way to explain it. The manager also added a line to the guide reminding staff that the tax is deferred rather than removed, so that nobody would be surprised when they withdrew money in retirement. She asked the payroll provider to show the year-to-date contribution on every payslip, which helped staff track their progress towards their limit.
Watch out
Common mistakes.
- Contributing more than the available room and incurring a monthly penalty on the excess.
- Withdrawing money early and losing both the contribution room and the tax advantage.
- Assuming that the tax refund is a bonus, when the tax is simply deferred until withdrawal.
Questions
People also ask.
Who should use an RRSP?
It is most attractive to people with a fairly high income now who expect a lower tax rate in retirement.
How does an RRSP differ from a tax-free savings account?
An RRSP gives a deduction now and taxes withdrawals later, while a TFSA gives no deduction but allows tax-free withdrawals.
What happens to an RRSP at a certain age?
It must be converted to a RRIF, an annuity or cashed out by the end of the year in which the holder reaches the age set in the tax rules.
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