Are RRSPs the Right Investment for You?

Canadians are often told they need to purchase RRSPs (Registered Retirement Savings Plan) in order to save for retirement. However, when taking a closer look at each unique person’s strategy for financial success, is this truly the right investment for every single person? Not necessarily. 

While RRSPs are extremely beneficial, they are not a one-size fits all solution to saving for retirement. 

Let’s examine the ups and downs of a RRSP. For the easiest example, we will use the following scenario:

  • You are a Canadian person who works as an employee and receives a T4 for $100,000 per year.
  • The applicable tax rate on your income is 36% (26% federal and 10% provincial).
  • Upon retirement at the age of 65, your cash needs are only $45,000/year – in order to obtain this cash, you draw from your RRSP.
  • The applicable tax rate on your RRSP income is 25% (15% federal and 10% provincial).

 

THE RRSP BENEFITS 

The tax benefit for the above scenario is twofold:

Rate Difference

You will receive a tax deduction from your income in the year that you contribute which results in a deduction at a higher rate (36% in this case). 

The RRSP is then taxed when you withdraw at a later date, typically at a lower rate (25% in this case).

This results in a tax savings of 11% on those dollars based on a rate difference. 

Deferral

Plain and simple, by contributing to an RRSP you get to deduct tax now and pay it later, ideally at a lower rate when you withdraw!  

 

THE RRSP DOWNSIDE

There are a few important things to consider if you decide to pursue RRSPs: 

Income Levels

If your current income levels roughly equate to your estimated cash needs in retirement, then the tax on the deduction now and the income inclusion later, will be roughly the same. 

This Which means you would only be benefiting from the tax deferral noted above and NOT the rate difference.

Ideally, in order to take full advantage of the rate difference, RRSPs are more beneficial for individuals who have a higher income during their contributing years as compared to their cash needs up on retirement. 

Income within an RRSP

When distributions are withdrawn from an RRSP, they are taxed as RSP income (i.e. dividends and gains), regardless of the income that originally comprised those withdrawals. 

When funds are withdrawn from an RRSP, they are taxed as pension income on your personal tax return, instead of the type of income that was generated within the RRSP account (i.e. dividends or capital gains), which would be the normal treatment in a non-registered investment account. 

This may result in a less ideal tax situation for that type of income when it eventually hits your personal tax return.

For example, the Canadian tax system has mechanics that will tax different investment income streams differently.

  • Capital gains are taxed at 50%
  • Dividends have a gross up (meaning you are taxed on more than you receive) and a subsequent tax credit 
  • Foreign taxes paid are credited on your personal return if held outside of a registered account such as an RRSP or TFSA (Tax-Free Savings Account)

This means you will likely face a tax loss on that income if you prefer to invest largely in dividends, capital gain generating investments, or foreign investments within your RRSP. 

Liquidity

RRSP accounts are registered which means there are more hoops to jump through in order to make a withdrawal. Withdrawals also become a part of your income, and must be included on your personal tax return in the year of withdrawal.

This is the opposite of more “liquid” accounts such as TFSAs, non-registered accounts, or cash accounts that allow you to freely move funds around mostly without any tax consequences

For this reason, any short term investments are best held outside of a RRSP account, when there will be less of a tax impact upon cashing in said investments. 

Age Dependent

RRSPs can have larger benefits work better the closer you are to retiring. This is because the rate difference mentioned earlier is realized much sooner when you contribute closer to retirement age (and your income is in a higher bracket prior to retirement). 

Make sure to talk to your accountant about the best options for you – waiting out a return on an RRSP may or may not work best for your long term goals. 

 

OTHER CONSIDERATIONS

There are a few other items worth noting regarding RRSPs that may help you choose if they are the right investment for you: 

Spousal RRSPs

These plans allow for a deduction on the contributor’s side and an income inclusion on the spouse upon withdrawal. This means you can provide retirement income for a spouse, while receiving a tax deduction for yourself. 

These are a great way to shift funds to the lower-income spouse into retirement. 

Over-Contributions

The annual contribution increase to your RRSP is 18% of your prior year earned income (i.e. wages), or $27,230 (as of 2020) of your earned income (i.e. wages). If you over-contribute to your plan, CRA charges you 1% per month on the over-contributed amount via a tax bill. 

Always check your annual contribution limit with your Notice of Assessment, or confirm with your accountant to avoid having any over contribution issues.  to pay the 1% fee on over contributed funds, as well as tax on the funds you are required to withdraw to meet said contribution limits. 

Incorporated Individuals

If you have a company, chances are that the most tax advantageous avenue for you will be to accumulate funds within the company, rather than take the funds out. Investing in an RRSP typically causes higher personal taxes, as the funds have to be taken out of the company, causing personal taxes in the process.

 

RRSPs can be a great investment tool. 

However, depending on your circumstances, there are many investment structures that may be more beneficial than an RRSP. Make sure to talk to your accountant to help identify the best strategy for you and your financial success. 

 

Looking for more information, or a consultation? Contact our offices or book an appointment through our simple online system. We are currently offering appointments through zoom video chat, over the phone, or in-person at one of our offices. 

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