Is an RRSP always the best choice for retirement?

Registered Retirement Savings Plans (RRSPs) are a cornerstone of many Canadians’ strategy to save for life after work. According to figures released by Statistics Canada in 2023, 22.4% of all those who filed taxes in 2021 contributed an all-time high median amount of $3,890 to an RRSP.

While there’s no doubt RRSPs remain an excellent way to save for retirement, they’re not the only tool in the box. Moreover, in some situations, other types of accounts can possibly be more effective. Let’s look at some key advantages of RRSPs, along with when they work best and when they may not work as well.

Available contribution room

You acquire RRSP contribution room based on the income you earn. In 2024, you can contribute 18% of your 2023 earned income, minus pension adjustments, up to a maximum of $31,560.

Some Canadians have substantial unused RRSP contribution room, but many also bump up against their limit every year. Contributing beyond the limit results in a significant tax penalty of 1% per month on overcontributions above $2,000. So, if you want to save more than your RRSP allows, you need to explore additional options.

Choices to consider for retirement savings include Tax-Free Savings Accounts (TFSAs) – though they have a contribution limit, too – and non-registered accounts.

Tax deductions for contributions

One of the biggest motivators for people to make RRSP contributions every year is the resulting tax deduction. The full amount of your RRSP contribution is deductible from your taxable income. If you have a high marginal tax rate, you could get upwards of 50% of your contribution back – either applied against the taxes you owe or in cash as a tax refund.

Saving taxes is generally a good thing. However, the money inside your RRSP must eventually come out. Although you can make RRSP withdrawals at any time, your RRSP matures on December 31st of the year in which you turn age 71, and withdrawals become inevitable. RRSP withdrawals, at any time, are 100% taxable at your marginal tax rate at the time of withdrawal. If your taxable income when you contribute to your RRSP is higher than when you withdraw, the net result will be a tax savings overall. But if the opposite is true and your taxable income is higher in retirement, you may want to consider saving for retirement in a different type of account.

Tax-deferred growth

Another important feature of RRSPs is that money grows on a tax-deferred basis inside the account. This gives a significant boost to the compounded returns you can achieve inside an RRSP compared to a non-registered account.

For example, let’s say that you have a marginal tax rate of 40%, and you invest $10,000 in a guaranteed investment certificate (GIC) in an RRSP and another $10,000 in a GIC in a non-registered account. Both GICs have a term of one year and pay 4% interest. When the GIC in the RRSP matures, you get to keep the full $400 in interest income and reinvest it as you choose. On the other hand, when the GIC in the non-registered account matures, you have to pay $160 in tax and are left with just $240 to reinvest.

But there’s another important aspect to consider. Some types of income are taxed more favourably than the interest income earned by a GIC. For example, capital gains and dividends from Canadian corporations are taxed at significantly lower rates than interest. This means that it may be beneficial to consider holding investments such as stocks and stock-based funds in a non-registered account and hold interest-generating investments such as bonds and GICs in your RRSP.

This strategy is known as asset location, because where you hold assets can be as important as what you own. It’s a way to take advantage of one of an RRSP’s best features, while preserving the tax benefits that come from earning certain types of investment income in non-registered accounts.

A mix of accounts often works best

RRSPs are an important part of many people's financial strategies – but using a combination of accounts helps you fine-tune your strategy to your unique goals. This can help you make the most of your retirement savings. In the end, you and your Edward Jones advisor can work together to determine the best mix for your specific circumstances.