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Investing for Retirement 2: What exactly is an RRSP, anyway?

Before I go any further in blogging about RRSP deadlines and retirement planning, I feel the need for a back-to-the-basics post. Truth is, many people I talk to don’t understand what an RRSP is – and that includes people who have been contributing for years.

RRSP stands for Registered Retirement Savings Plan. An RRSP is a type of account for holding savings and investment assets.

This is an important point. An RRSP is an account, not an investment. Every year, many times a year, I hear people talk about “buying RRSPs” or “investing in RRSPs.” Think of bank accounts. You may open a savings account, a chequing account, a high-interest account, or etc. These are all types of accounts you put money into, for different purposes. An RRSP is a type of investment account. The account is registered with the Canada Revenue Agency, and is primarily designed for retirement savings.

Within your RRSP account, you may hold any of the following types of investments: cash, guaranteed investment certificates (GICs), bonds, mortgage loans, mutual funds, income trusts, corporate shares (stocks), foreign currency and labour-sponsored funds. This may vary depending on where you have opened your RRSP and the kind of investments the institution sells. You may open your registered retirement savings plan through a financial institution such as a bank, credit union, trust or insurance company. Your financial institution will advise you on the types of RRSPs available, and the investments they can contain.

There are a variety of RRSP rules which determine the amount you are able to  contribute each year, the timing of contributions, how to claim your contribution tax credit, the types of investments allowed in the account, and the eventual conversion of the RRSP into an RRIF (Registered Retirement Income Fund) in retirement. More information can be found on the Canada Revenue Agency’s website.

There are three main benefits to using an RRSP for retirement savings:

  • Taxes on any income contributed to an RRSP are deferred until the funds are withdrawn, in the form of a tax credit.
  • Because you defer paying tax until you withdraw the money at a later date, presumably at a lower retirement level income, most people will pay less tax over all. (This is not true if your retirement income or tax rate is equal to or greater than it is when making contributions).
  • Income earned on the money invested inside the RRSP is not taxed either while within the plan or on withdrawal.

You also have the option of setting up a spousal or common-law partner RRSP. This type of plan can help ensure that retirement income is more evenly split between two partners. In this case, the higher-income partner contributes to an RRSP for the lower-income partner. The contributor receives the tax deduction, which is worth more to a higher income earner. The lower income spouse receives the income during retirement, likely to be taxed at a lower rate – again leading to decreased overall tax costs.

There are limits on how much can be contributed to an RRSP and claimed on a tax return each year (though few people actually contribute the maximum allowed*). Your exact limit is calculated by Canada Revenue Agency (CRA) based on your income, pension contributions and deductions, and past unused contributions room, which is carried forward year to year. Put simply, each year you are allowed to contribute up to 18% of your previous year’s salaries, plus any unused room, less an adjustment for pensions activity. Regardless of your income, there is a cutoff amount you cannot exceed, which in 2010 is set at $21,000 and will increase each year with the annual increase in the average wage.

Your RRSP deduction limit will be sent to you each year by CRA, and can be found either at line (A) of the RRSP Deduction Limit Statement, on your latest Notice of Assessment or Notice of Reassessment, or on a T1028, sent after the processing of your previous year’s tax return.

The deadline for contributing to your RRSP and claiming a deduction on your 2010 tax return is March 1, 2011. For this reason, January and February have been dubbed by those in the finance industry as the “RRSP season.”

* According to this year’s RBC RRSP Poll, 61 per cent of Canadian Adults have RRSPs, and a quarter of them (24 per cent) plan to maximize their contribution for 2010.

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