What a RRSP isn't is a specific investment. A RRSP is really just a special
investment holder or account, or, if you like, piggy bank. You can hold a great variety of
different investments inside the account. You can even hold many different types of
investments inside the same RRSP.
What makes a RRSP special is that in return for agreeing to leave the money inside the
plan, you get two tax benefits - first, you can move some of your income into a RRSP
without it being taxed. Second, once inside a RRSP the money grows tax-free.
What are the benefits of a RRSP?
RRSPs have two major advantages:
- Tax-deferred
contributions.
- Tax-sheltered
growth.
Tax-deferred
contributions
If you contribute income to a RRSP, you don't have to pay tax on that money. For instance,
say you make $75,000 per year. If you contribute $5,000 to a RRSP, you can deduct $5,000
from your taxable income for that year. You save the tax you would normally have had to
pay on that $5,000.
Tax-sheltered growth
Once you have money or investments inside a RRSP, they can earn profits for you without
being taxed while inside a RRSP, interest, dividends, and capital gains you make on the
money inside your plan aren't subject to any tax. All your profits can go back to work for
you.
Why are RRSPs such a powerful tool for saving?
Once you add the power of tax-free compounding to tax-deferred contributions you have a
real money-making machine. To show you just how powerful RRSPs are, let's compare the
different outcomes of investing $5,000 of your income inside and outside a RRSP. Assume
your income is $75,000, which puts you in the top-tax bracket.
Investing outside a RRSP
Suppose you wanted to invest $5,000 of your salary. If you didn't use a RRSP, you'd first
have to pay tax of up to almost 50% (depending on your province of residence). That leaves
you with $2,500 to invest.
You then invest the money in an equity mutual fund. Suppose your money is 100% in stocks,
and you earn a 10% pre-tax profit, all of which is in capital gains. Capital gains are
taxed at half your marginal tax rate, or 25%. Assume you sold your investment a year after
you bought it, you would lose a quarter of your profits. This means that you really only
made an after-tax return of 7.5%. If you continue to buy and sell investments in each year
for 20 years, the original $2,500 investment would be worth almost $11,000.
Investing inside a RRSP
If you invested $5,000 of your salary in a RRSP, you would be ahead right off the start.
You could put the full $5,000 to work, as it wouldn't be taxed.
Once inside your plan, any profits you make also aren't taxed. If you earn an average of
10% a year in the stock market, you would be able to enjoy a 10% average annual compound
return. After twenty years you would have over $33,000. That's 3 times the savings you'd
have investing outside a RRSP.
If you take the money out of your plan, it's taxed. But even assuming it's all taxed at
the 50% marginal tax bracket, it would still be worth almost $17,000. That's still over 1
˝ times the savings you'd have investing outside a RRSP.
The RRSP edge
Investing inside a RRSP is hands down the better option. First, using pre-tax dollars
means you have more money working for you. Second, your savings grow faster because you
can reinvest all your profits without paying tax.
In our example above, saving $5,000 of your salary in a RRSP means that after 20 years,
you'll have 50% more saved up. Instead of the almost $11,000 you'd have if you hadn't used
a RRSP, you would have nearly $17,000, or an extra $6,000!
How much can I put into a RRSP?
There are three factors that affect how much you can contribute to a RRSP:
- A percentage of
your previous year's earned income
- A maximum
dollar contribution
- An adjustment
for your pension
A
percentage of your previous year's earned income
Each year you are working, you earn the right to contribute up to 18% of your gross income
(technically, your earned income) to a RRSP in the next year.
For example, say you made $60,000 before taxes in 2001. That earns you the right to
contribute up to 18% of $60,000, or $10,800 to your RRSP in 2002. (The most you can
contribute is the lower of $13,500 and 18% of your previous year's earned income.)
However, if you haven't used up your contribution room from previous years, you can
contribute more than the maximum.
So just what is your earned income? If you are an employee, this is generally your salary
- the gross amount you make before deductions. If you are self-employed or are an active
partner in a business, it also includes any business income.
A maximum dollar contribution
The most you can contribute in a year is $13,500, up to and including the 2003 tax year.
For 2004, the dollar limit will be increased to $14,500, and for 2005, $15,500. After
that, the dollar limit will be indexed, rising at the same rate as the cost of living.
An adjustment for your pension
If you belong to a pension plan, this will also affect how much you can contribute to a
RRSP. First, the government starts off with your allowable contribution - currently
$13,500 - or 18% of your previous year's earned income, whichever is lower. Then it
deducts an estimate of the increased value of your pension during the previous year. In
other words, the more both you and your employer contribute to your pension plan, the less
you can put into to a RRSP.
The amount used to represent the value of the pension contribution is called your pension
adjustment, or PA. So your allowable contribution becomes the maximum contribution allowed
or 18% of your previous year's earned income, whichever is less, minus your pension
adjustment.
How is earned income calculated?
Here are the details on just how Canadian Customs and Revenue Agency (CCRA) determines
what your earned income is.
Earned income includes:
- Your salary.
- Net income from
self-employment or being an active partner in a business.
- Research grants
(after deducting any related expenses).
- Royalties from
works or inventions.
- Taxable alimony
and maintenance.
- Taxable child
support payments.
- Net rental
income (rents less any deductible rental expenses).
- CPP/QPP
disability pensions.
Earned
income is reduced by the following:
- Any deductible
alimony, maintenance, and child support payments you make.
- Most deductible
employment-related expenses, such as union dues and travelling expenses.
- Rental losses.
What's
not included as earned income?
- Interest
income.
- Dividends.
- Capital gains.
- Pensions
benefits.
- Retiring
allowances.
- Severance pay.
- Death benefits.
- Withdrawals
from a RRSP or RRIF (Registered Retirement Income Fund).
- Payments from a
deferred profit-sharing plan.
When
can I make a contribution?
You can make a contribution to a RRSP any time you wish as long as you have some
contribution room available. Contribution room available simply means you have earned the
right to put some money into a RRSP that you haven't yet entirely used up. You can put a
full year's contribution in at one time, or sporadically, as money becomes available. You
can also arrange to have a set amount taken off your pay cheque every pay period and put
into your plan.
When is the deadline for making a contribution?
The deadline for RRSP contributions is the sixtieth day following the tax year. For
instance, the RRSP deadline for the 2002 tax year is March 1, 2003.
It's important to realize just what this means. First, it isn't the deadline for when you
have to make a contribution. You can make a contribution any time you wish, as long as you
have some contribution room available. The deadline is simply the date by which you have
to make a contribution if you want to claim a deduction for it in a specific tax year.
What happens if I can't contribute my full allowable amount?
If you can't contribute the maximum in a year, you keep the right to put that money into
your RRSP any time in the future.
For instance, say your earned income last year was $80,000. That would mean you could put
in up to 18%, or $14,400. However, you would be capped at the dollar limit of $13,500.
Now suppose you only put $10,000 into your plan, leaving $3,500 of contribution room
unused. In any future tax year, you can contribute that $3,500 to your RRSP in addition to
your regular allowable contribution.
Can I take money out of my RRSP?
Yes. The money is yours to withdraw whenever you wish. However, when you take money out of
your RRSP, it is included in your regular taxable income for that year. The money from
your RRSP will be taxed at your marginal tax rate. This is true even if you're withdrawing
dividends or capital gains inside your plan, which normally would be taxed at a lower
rate.
If you are buying a house with the RRSP money, the rules change. If you qualify, you can
withdraw a maximum of $20,000 tax-free as a loan from your RRSP to buy a house. However,
there are strict conditions you must follow:
- If you withdraw
your contribution within 90 days, you can't deduct the contribution from your income.
- You must repay
all the money to your RRSP within 16 years.
- You must start
to repay the money the second year after you make the withdrawal.
- The minimum
annual repayment amount is 1/15 of the money you borrowed.
- If you miss a
payment, the payment amount is added to your taxable income for the year.
How
old do I have to be to have a RRSP?
Anybody can have a RRSP as long as they have earned income. Even children who earn money,
from a paper-route or working at a convenience store, should file a tax return. By making
the government aware that you've earned an income, you earn the right to contribute to a
RRSP. You can build up the contribution room and carry it forward over the years. So when
you do start to make enough income to be taxed, you cut your tax bill by using your back
contribution room.
How long can I have a RRSP for?
You have to close your RRSP by the end of the year in which you turn 69.
What are my options when I have to close my RRSP?
You have three choices:
- Take the money
in cash.
- Use the funds
to buy an annuity.
- Transfer the
holdings to a Registered Retirement Income Fund (RRIF).
Take
the money in cash
This is an easy, but costly, move. The money will be included in your taxable income for
that year, and taxed at your marginal rate. In some cases, you'll lose up to almost half
your savings to taxes.
Buy an annuity
If you use your RRSP savings to purchase an annuity, the money isn't taxed. The payments
you receive from the annuity are taxed when you receive them. If you choose an annuity,
you're locked in. You can't change your mind and convert to a RRIF.
Transfer the holdings to a Registered Retirement Income Fund (RRIF)
If you move money directly from a RRSP to a RRIF, you don't have to pay tax.
This option offers the most choice and flexibility. A RRIF is very similar to a RRSP. You
can generally invest in the same range of investments, and your money can grow tax-free.
The main difference is you can't make contributions to a RRIF. Instead, you are required
to withdraw a set minimum amount from your RRIF each year. This money, like withdrawals
from a RRSP, is added to your regular income and taxed at your marginal tax rate. If your
cash needs fluctuate, you can take out more than the minimum. You can even use money from
your RRIF to buy an annuity. |
