Registered retirement savings plans: Beyond the basics

Registered Retirement Savings Plans (RRSPs) have been available to Canadians for more than half a century and for many people they are the backbone of a retirement savings strategy. Being able to contribute the maximum annual contribution is often regarded as the very definition of retirement saving success. But there’s a lot more investors should be aware of beyond the basics.

A quick review of the fundamentals

RRSPs allow individuals to save for retirement in a tax-preferred way by:

1. Creating a tax deduction on contributions, which can be used to reduce the amount on which income tax is calculated, and;
2. Providing for tax-deferred growth and income on the underlying investments up until funds are withdrawn or the plan is deregistered.

Contributing to an RRSP:

The amount you can contribute each year is based on:

• “earned income” from the previous year,
• unused contribution room from previous years, which can be carried forward indefinitely,
• pension adjustments (e.g. employer pension plan contributions), and the maximum contribution limit set annually by the federal government.

Generally speaking, if you have no unused contribution room and no pension adjustments, your “contribution limit” in any given year will be the lesser of:

• 18% of your annual earned income, and
• the maximum limit set by the government ($29,210 in 2022, increasing to $30,780 in 2023)

Withdrawing from an RRSP:

You can withdraw funds at any age, but there is typically an immediate withholding tax and subsequent inclusion in income, which will be taxed at your marginal rate. Additionally, the RRSP contribution room does not regenerate once funds are withdrawn – the room is lost forever.

An RRSP matures on December 31st of the year in which you turn 71 years old, at which time you must:

• withdraw the funds and include them in your annual income,
• transfer them to a Registered Retirement Income Fund (RRIF) or use them to purchase an annuity.

Beyond the basics

But there are many more things to consider when it comes to RRSPs. Let's explore some of the lesser known aspects.

It's not just employment income that creates contribution room

RRSP contribution room is based on certain types of "earned income" as defined in the Income Tax Act, and includes net income from employment (including salaries, bonuses, tips and gratuities), net business income from self-employment or as an active partner in a business, and net rental income from real estate. Disability income from Canada Pension Plan (CPP) or Quebec Pension Plan (QPP) disability pensions, spousal support received and royalties can also create contribution room. The list is broader than many people realize, and these different types of income may create additional planning opportunities. What isn't included in the definition is most forms of passive investment income, such as capital gains, interest and dividends.

The type of investments you can hold may be broader than you realize

Many people mistakenly believe that RRSP accounts can only hold Guaranteed Investment Certificates (GICs), mutual funds or Exchange Traded Funds (ETFs). While those may indeed be the best approach for a particular individual, others may benefit from including a mix of stocks and bonds in their RRSP account. However, there are limits to the types of investments that may be held in these and other types of registered accounts. Investments must meet the definition of “qualified investments”; a term that is defined in the Income Tax Act. Ineligible investments (like commodity futures) held in an RRSP may attract significant negative tax consequences (including a 50% tax on the value of the prohibited investment), so make sure investments qualify before acting.

You can use your RRSP to fund home purchases, education goals and help family members who have disabilities

While RRSPs are a long-term retirement savings vehicle, they do offer some flexibility to help achieve other financial goals in the right circumstances.

The Home Buyers' Plan (HBP) allows you to withdraw up to $35,000 from your RRSP to buy or build a qualifying home for yourself or for a related person with a disability. The HBP allows you to take up to 15 years to pay back the withdrawn funds, with repayments starting in the second year after the first withdrawal.

Similarly, the Lifelong Learning Plan (LLP) allows you to withdraw up to $10,000 in a calendar year to a total LLP limit of $20,000. The LLP funds can be used toward any purpose, provided you (or your spouse or common law partner) meet the LLP conditions when you make the withdrawal. You must repay amounts withdrawn over a 10-year period starting the fifth year after the first withdrawal.

Both the HBP and the LLP limits are personal to the individual, meaning partners or spouses can each withdraw the maximum and use the total funds toward a common home or education goal.

In addition to permitting funds withdrawn under the HBP to be used to buy or build a qualifying home for a related person with a disability (even if you don't qualify as a "first time home buyer"), the Income Tax Act also allows for a rollover of a deceased individual's RRSP to the Registered Disability Savings Plan (RDSP) of a financially dependent (due to physical or mental disability) child or grandchild.

You don’t need to claim the deduction in the same year you make the contribution

This is one of those little-known facts that can have a big impact on your bottom line: Just because you contribute to your RRSP for the benefits of tax deferral on the underlying investments, doesn’t mean you need to claim this deduction against your income for the same tax year.

You may choose to hold on to this deduction amount (all or some) for use in a future year. This could result in significant savings if, for example, you knew you would have higher taxable income in an upcoming year. There is no time limit for how long you can carry forward the allowable deduction.

The tax bill on death can be the biggest you’ve ever paid

Many people include the full value of their RRSPs when they think about what their estate would look like if they were to prematurely pass away. In fact, the full value of your RRSP would be included in income in your year of death and taxed at what may be the highest marginal rate you’ve ever been subject to. For example, assuming you had no other taxable assets, a $200,000 RRSP would be subject to an average tax rate of more than 30% and hit a marginal tax rate of nearly 50% in some provinces. There are tax deferral opportunities for spouses and children or grandchildren who are financially dependent due to disability, however there are pitfalls that the unwary may fall into if proper advice isn’t sought.

You can still contribute to a spouse or common law partner’s RRSP after you turn 71

An RRSP matures on December 31st of the year in which you turn 71 and contributions can no longer be made to your RRSP. They can, however, still be made to a spouse’s or common-law partner’s RRSP until the end of the year in which the spouse turns 71. This provides a planning opportunity where an individual has carried over contribution room or continues to accumulate it by accruing earned income after age 71 and has a younger spouse or common law partner. It could, for example, mean the contributing spouse is subject to reduced Old Age Security (OAS) clawback while providing tax-advantaged savings opportunities for the recipient spouse. This is a significant planning opportunity that is often overlooked.

RRSP contributions can make the difference in qualifying for other benefits

It’s worth a careful look at the details to see whether an increase in your contribution could mean you qualify for income-tested benefits you may be on the cusp of receiving. For example, a reduced net income (as a result of RRSP contribution and deduction against your income) could lead to increased refundable tax credits, like the GST/HST credit, or increased income-tested benefits like the Canada Child Benefit.

Sometimes it makes sense to make RRSP withdrawals before retirement

Most individuals just forget about their RRSPs until retirement because they think it’s locked- in or assume massive tax liabilities. The reality is that there are many times where it may make sense to withdraw funds from an RRSP. For example, if you’re in a year of low relative net income and have an urgent need for additional funds because of maternity or paternity leave or unemployment, accessing your RRSP may be the best of the available options.

It may also make sense to begin a drawdown strategy in the years leading up to retirement. If you anticipate you’ll be in a high tax bracket in retirement, drawing down on your RRSPs early may reduce the likelihood of OAS clawback or help keep the marginal rate lower over the long term. Taking a careful look at all the details is critical in these situations.

There's much more than meets the eye when it comes to RRSPs. Your Edward Jones financial advisor can help build your understanding and determine the best strategy for you.