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Jan 4, 2023

Why Are You Saving In An RRSP?

by Julie Petrera

What Is An RRSP?

A Registered Retirement Savings Plan (RRSP) is a type of registered account that millions of Canadians contribute billions of dollars to every single year. The RRSP was created in 1957, making the RRSP itself 65 years old, the average age of a retiree in Canada.

High Level:

  • RRSPs can be held by anyone under age 72 in Canada with employment or business income;
  • Contributions to an RRSP are tax-deductible at the contributor’s marginal tax rate (MTR) in the year of deduction, meaning they lower the taxpayer’s taxable income that year;
  • Money deposited in the plan can be invested in a variety of investments;
  • Investments grow within the plan on a tax-deferred basis, and no tax is paid on gains until withdrawal;
  • Withdrawals from the plan are taxable as income at the taxpayer’s MTR in the year they are withdrawn;
  • Withdrawals from an RRSP go into the “income test” which is used to determine eligibility for other government programs like Old Age Security; and
  • RRSPs mature on December 31 of the year the holder turns 71.
  • To summarize, you get a deduction when money goes in and pay tax on it when it comes out. So, is this account type right for you? That depends—but first, what is an RRSP not?

What Isn’t An RRSP?

An RRSP is not a retirement plan. A plan of any kind is defined as an organized method of achieving an end goal. So how, then, does an account type become an organized method? And what is the end goal? That’s where the question comes in: “WHY are you saving in an RRSP?”

What Is A Retirement Plan

A retirement plan is a clear path to the end goal. The goal is retirement. But to organize a plan for this goal, you have to determine when and where you want to retire, who you want to retire with, what you want to be doing in retirement, and what you want to be outsourcing. The answers to these questions can be used to determine how much your retirement is going to cost.

Once you know the cost, you need to determine where the money to cover those costs will come from. It could include earned or passive income (like wages, commission, rent or investment returns, Canada Pension Plan (CPP) benefits, Old Age Security (OAS), the Guaranteed Income Supplement (GIS), employer-sponsored pension plans benefits, and withdrawals from your RRSP (which, at that time, if it’s after age 71—could be a RRIF or an annuity).

With an RRSP being just one component, you should be able to answer all the other questions first to know why you’re contributing to it.

If you’re able to determine the cost of your retirement and the income you already plan to collect toward it, the RRSP can be used to save for the shortfall. Step one is to understand if a shortfall exists and, if so, what’s the size of the shortfall. And then you need to determine if an RRSP is the right account type in which to save for that shortfall.

 

Why Do Millions Of Canadians Contribute Billions Of Dollars To RRSPs?

That’s the million (or billion) dollar question. Many people contribute to RRSPs “today” to reduce their taxable income this year. They want to reduce the income tax payable immediately. But if your goal is to save tax, and you contribute more than you’ll need in retirement, or you plan to earn income in retirement—you could end up paying MORE tax upon withdrawal than you’ll save today. Simply making contributions today could have the opposite result you’re looking to achieve by contributing to an RRSP in the first place.

The RRSP’s Competitor

Thirteen years ago, a younger, more flexible account type emerged; the Tax-Free Savings Account (TFSA). While this account doesn’t have the words “retirement” or “plan” in it, it can be used to save for retirement or any other planning goal between now and then.

High level:

  • Anyone over 18 can open a TFSA;
  • Contributions are not tax-deductible;
  • Money deposited in the plan can be invested in a variety of investments (similar to RRSPs);
  • Investments grow within the plan on a tax-free basis;
  • Withdrawals are tax-free; and, therefore, do not go into the income test used to determine eligibility for other government programs; and
  • Funds withdrawn from the plan can be re-contributed the following calendar year.

TFSAs are very flexible and forgiving and might be suitable for those of you that can’t articulate when and where you want to retire, who you want to retire with, what you want to be doing in retirement, and what you want to be outsourcing.

RRSP Or TFSA?

It depends—but not on any factor that can be articulated in an article. It depends on your personal situation. It depends on when and where you want to retire, who you want to retire with, what you want to be doing in retirement, and what you want to be outsource. It depends on how much your unique retirement is going to cost and how much income you plan to collect to fund it from other sources. It depends if there is a shortfall, and if it is, it depends whether you prefer tax deferral or saving tax altogether, how highly you value flexibility, and how important an immediate tax refund is to you. Once you can answer these questions, you can build a plan: an organized method of achieving an end goal. And while both RRSPs and TFSAs could be valuable inputs in the roadmap, neither is a retirement plan in and of itself, and the decision of which to contribute should start with your “Why?”.

Julie Petrera, MBA, CFP, CIM is a certified financial planner. Twitter: @petrerajulie