A New Canadian’s- Finance 101- RRSP

As a new Canadian set afoot on the Canadian snow, you would probably be worried about the best practices to save your money in an alien country that you are soon to be calling as your home. I have news for you- so was I. As Shakespeare rightly put, “Money is a good soldier, and will on.”- which essentially means, “you should be putting your money to work for you.”

So in this Series of articles, I am trying to untangle the world of Canadian Finance to you. In India, we have only savings account for individuals and current accounts for businesses and all other financial products like stocks, insurance, FDs etc are either sold to you separately or there is a different entity altogether involved, with less overlap on each financial products. For instance, I receive my salary in a bank account while I buy shares using a brokerage, which in turn maintain a separate demat account.

On the other hand, in Canada, there are separate accounts maintained with banks or other financial institutions to tailor to the financial needs of an individual and with overlap between financial products. For instance, when I say my holdings in RRSP account, for instance, it may include cash, stocks, mutual funds, GICs, gold etc.

In the first article, I will try to break it down to you, an account that helps you to plan for your sweet retirement. Behold, my fellow new Canucks, let me introduce you to that tool which helps you harvest the benefits of the eighth wonder in thy world- compounding your way to retirement, which goes by the name RRSP.

RRSP or a “Registered Retirement Savings Plan” is a tax-sheltered account provided by the government to help Canadians to save for their retirement.

I. How so ye ask?

When you contribute some assets to your RRSP account, you get what Canadians call, ‘a tax break’. This means, the contributions you make are tax-deductible and any returns generated in your account stay untaxed and continue to grow until you start making withdrawals down the road. This is by design. This is a perfect way to stay motivated long enough for compounding machine to work its magic.

Types:

  • Individual RRSP: The RRSP account is opened by you directly, under your name, you are the one making all the contributions and claim tax benefits;
  • Group RRSP: If you’re employed, your employer may also offer a group RRSP plan which allows employees to save for retirement, all the while the employer may also contribute his share of the pie to your retirement. Mostly, the employer makes sure that the employee contributions are made automatically through payroll deductions.
  • Spousal RRSP: This is a pretty awesome setup where the higher-earning spouse can contribute to the RRSP account of the other spouse as a means of splitting retirement income and lowering the couple’s overall tax burden in retirement. The contributor claims tax-deduction on the amount they contributed. When funds are withdrawn in retirement, the spouse who owns the account pay taxes based on their own tax rate.

II. Investments that are allowed under RRSP

All investment instruments that you can hold as a way of contributing to the account are referred to as ‘qualified investment’. These can include, mutual funds, bonds, Exchange-Traded Funds (ETFs), GICs, Stocks (Equities), Real Estate Investment Trusts (REITs), cash, investment-grade gold and silver bullion, coins and bars.

III. Is there a Contribution Limit to the amount in RRSP?

Yes, every year, the government allows you to contribute up to 18% of your “earned” income for the previous tax year. For example, for 2018, you can contribute 18% of the income you earned in 2017, up to a maximum amount of $26,230. This income can be from any variety of sources, including employment, rent, royalties, alimony, research grants, business income, etc. Unused contribution room can be carried forward indefinitely and this will increase how much you can contribute in future years. This is referred to as your ‘contribution room’. That is the current years limit plus previous years limits carried forward to this year if any.

Eg: Year 2018 limit- $26230+ last years contribution room unused ($5000)= $31,230.

IV. How to know your Contribution Room?

You can confirm what your current total RRSP contribution room is by checking the Notice of Assessment (NOA) you received from Canada Revenue Agency (CRA) for last year’s tax return.

V. Penalty

If you’re thinking, you will contribute every penny you’ve got to RRSP, to retire early, not so easy, amigo! If you contribute more than the contribution room each year, the taxman will slap you with a penalty tax. This tax is 1% per month on cumulative excess contributions exceeding $2,000. Everyone gets a once in a lifetime pass for $2,000 in excess RRSP contributions before penalties kick in.

For example, if you have had over contributed to the tune of $3,000 in your RRSP account, a monthly penalty tax of 1% per month will be levied on $1,000 (that is $3,000 minus the $ 2,000-lifetime exception) every month until the excess amount is withdrawn.

Using this example, this amounts to :

  • $1,000 x 1% = $10 per month or $120 per year in over-contribution penalty.

VI. Withdrawals

Retirement and all is fine but I am a hedonist and I want that money for that Great Canadian road trip and then a trip to Machhu Pichhu, in Peru. Well, rightfully so, you deserve to celebrate once in a while. So you are allowed to withdraw funds from your RRSP at any given time whatsoever. However, the catch here is that taxes become due immediately after withdrawal.

Depending on how much you withdraw, the bank will withhold taxes and pay it to the government on your behalf. Funds withdrawn are also included in your taxable income for the year and depending on your tax bracket, more taxes may be due at tax time.

That is withholding taxes by bank plus taxes based on your marginal tax rate (tax slab) for the year.

The Biggest Caveat of Them All- 

In addition to taxes, when you withdraw from your RRSP before retirement, you lose that portion of your contribution room permanently, except in a few cases.

The government has provided some options for Canadians to make withdrawals from their RRSP without incurring taxes and losing their contribution room.

They include:

  • Home Buyers’ Plan (HBP): This plan allows first-time home buyers to withdraw up to $25,000 from their RRSP in order to purchase a home. A couple can withdraw up to $50,000 ($25K each). You have up to 15 years to repay the amount back to your RRSP; 
  • Lifelong Learning Plan (LLP): This plan allows you to withdraw up to $20,000 from your RRSP to pay for further education for you or your spouse. You are required to pay back the amount withdrawn in 10 years.

VIII. Tax Benefits of RRSP

  1. Tax-Deductible Contributions:

Whatever you contribute to your RRSP are pre-tax income. This means any taxes incurred on your RRSP contribution is paid back to you at your marginal tax rate.

For example, if your marginal tax rate is 40% and you contribute $20,000 in after-tax employment income to your RRSP in 2018, you can expect a tax-relief or refund of: $20,000 x 40% = $8,000.

At the time of filing your return, you will get a tax-relief because your taxes are computed on your gross income less your contributions, resulting in lower income taxes.

You can also choose to have your taxes reduced at source, so you don’t have to wait until filing your returns to get the tax benefits.

2. Tax-Free Growth: Remember, the ultimate aim of an RRSP account? Its retirement and the single most strategy that helps you achieve that is, compounding and all the earnings in an RRSP account remain sheltered from taxes until one start to withdraw funds. This means that dividends, interest income, and capital gains earned on the original investments made, all will remain tax-free and continue to compound over time until your retirement or should you decide to go back to your homeland someday.

3. Lower Tax in Retirement: There is no doubt that you will eventually end up paying taxes on an RRSP account, but you have successfully deferred taxes for so many years and all those small portions would have added up and by the time you retire or leave Canada, chances are that you will be at a lower tax rate in retirement.

4. Canada Child Benefit Scheme: When contributions are made to an RRSP, the deductions lower your net income. This, in turn, may increase your eligibility for other government benefit programs like The Canada Child Benefit (CCB) program because it is a refundable credit based on family net income.

VIII. Deadline for Contributing to RRSP

Contributions to RRSP can be made at any time on your convenience.

But a point you might want to consider is, if you want to claim your tax break when filing your taxes for a particular year, then you must have put in the contribution no later than 60 days after the end of the tax year (i.e. by February 29 or March 1 of the following year). So, for instance, to claim a tax break for RRSP contributions made during the 2017 tax year, the contributions must have been made before March 1, 2018.

What Do I Do At The Time Of My Retirement?

At your retirement, you can do one (or a combination) of these three things:

1. Withdraw Cash as Lump-Sum: Please note that CRA will levy taxes on the cash based on your marginal tax rate.

2. Convert Your RRSP to an RRIF: Your can move your funds into a Registered Retirement Income Fund (RRIF). Here, what happens is that your funds continue to stay invested on a tax-deferred basis just like in the RRSP. However, you are required to withdraw a minimum amount of income every year which is reported on your income tax return. Tax is paid on such withdrawals at your marginal tax rate.

3. Purchase an Annuity: You can purchase an annuity that pays you income in retirement. This can be term based or a life annuity.

IX. I want to move my RRSP from one financial institution to another, Can I do so?

You are allowed to transfer your RRSP from one institution to another without tax consequences. The transfer can be conducted “in kind” or “in cash.” Form T2033 is used to process direct RRSP transfers. A transfer fee may be applied. Many of the new generation ‘robo advisors’ and financial institutions, pay this transfer fee for you if you move your RRSP account to their institution.

That’s all folks!!

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