Understanding RRSPs:
The 6 Benefits
(And 7 Drawbacks)
of RRSPs
RRSPs are one of the three major tax shelters available to Canadians. They were created in 1957 and since then RRSPs have been a key way to delay and avoid taxes. There are many benefits to an RRSP but also a few drawbacks.
In general Canadians aren’t taking full advantage of this tax shelter. As of 2015 there was over $1 trillion of unused contribution room. That’s an average of $41,560 per tax payer!
Each year the unused contribution room continues to grow. Over the last 5 years unused contribution room has grown by $1,900 per person per year.
This begs the question….
Why aren’t we using the RRSP to its full advantage?
Out of all tax payers only 1 in 4 used an RRSP last year. While this might seem low it’s important to note that RRSPs aren’t for everyone. There are drawbacks to using an RRSP and it’s because of these drawbacks that some people choose a different tax shelter instead, like a TFSA (although TFSAs have their own drawbacks too!)
Still, there is a huge potential for tax savings out there. Even at the lowest federal tax rate the potential tax rebate is about $150 million or roughly $6,000 per person. Who wouldn’t like to get a $6,000 tax refund?!?
In this post we’ll cover how RRSPs work. We’ll also cover both the benefits and drawbacks of an RRSP.
How They Work
RRSPs are pretty simple. Contributions are made pre-tax and they grow tax free until withdrawal.
If a contribution is made with post-tax income then you’ll get your tax back at the end of the year.
When you eventually withdraw money from your RRSP its considered ordinary income and will be taxed at your marginal tax rate (and not just your marginal income tax rate, but also government benefit clawback rate too, the combination can reach 50%+)
RRSP withdrawals can be made at any point in time and without penalty.
RRSP withdrawals will incur a withholding tax depending on the size of the withdrawals. This withholding tax is just a pre-payment of your annual taxes, its not a penalty.
RRSP accounts help you defer tax, you won’t avoid tax all together, you just defer tax until retirement. This is why RRSPs are especially popular with high income individuals. They can defer tax until retirement when they’re in a lower tax rate.
We see the % of people who contribute to an RRSP rise quickly with income. Contribution rates go from just 21.5% of people in the $40k-$50k income range to 77.7% in the $200k-$250k income range.
RRSP Contribution Rate by After-Tax Household Income
[weblator_chart id=”22″]Source
Free Resources
The 6 Benefits of RRSPs
Certain Withdrawals Can Be Made Without Paying Tax:
RRSP contributions can be withdrawn without paying tax by using two programs. First time home buyers can use the Home Buyers Plan (HBP). And people returning to school can use the Life Long Learning Program (LLP). These programs have limits on withdrawals and require repayment over a period of 15 years. The benefit is that it allows people to make an RRSP contribution, get a tax refund, and then withdraw that money using the HBP and LLP without paying tax.
Withdrawals Can Be Made At Any Age:
One HUGE benefit of RRSPs is that they allow withdrawals before retirement. Retirement accounts from other countries, like the 401k in US, don’t allow withdrawals before retirement age. Because RRSPs allow withdrawals at any age they work extremely well for early retirees.
Contributions Are A Tax Deduction:
RRSP contributions are considered a tax deduction and will lower your net income. This can increase your income tested government benefits. This is on top of your income tax rebate. For certain families this can add up to 30-40%! When these families make a $1,000 contribution to their RRSP they would see an increase in their income tested benefits by $300-$400 the following year.
Protected From Creditors:
A little-known benefit, RRSP savings are protected from creditors, this includes claims from lawsuits or bankruptcy. Just like a pension, your RRSP can’t be used to cover liabilities from either a lawsuit or bankruptcy. This benefit isn’t available for TFSAs or RESPs, both can be seized to cover personal liabilities.
Tax Free Compounding:
A MASSIVE benefit of RRSPs is that any investment made inside an RRSP will grow tax free. This lets your investment compound much faster without the drag of annual taxes. The drag from taxes can be significant. The average Canadian family would experience a 15% drag due to capital gains tax and a 30% drag due to the tax on interest payments. Over 40 years this can cut $300,000+ off of your retirement savings. This can be avoided by using an RRSP. For more details check out the graphs below to see how the investment balance grows between the different accounts.
Potential For A Lower Lifetime Tax Rate:
Along with tax free compounding, another MASSIVE benefit of an RRSP is that you can lower your average lifetime tax rate. Contributions can be made during high tax years and withdrawals can be made in low tax years. A Canadian family putting away $5,000 per year can reduce their lifetime tax bill by $477,002 by using RRSPs to invest for retirement. Compare the cumulative withdrawals between RRSP and Taxable accounts. The tax efficiency of an RRSP allows for an extra $477,002 in withdrawals!
RRSP
Annual $5,000 Pre-Tax Contribution
$983,045 Cumulative Withdrawals (After-Tax)
[weblator_chart id=”23″]
Taxable
Annual $3,517 Post-Tax Contribution
$506,043 Cumulative Withdrawals (After-Tax)
[weblator_chart id=”24″]
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The 7 Drawbacks of RRSPs
Withdrawals Are Considered Ordinary Income:
RRSPs turn all kinds of income into ordinary income. Dividends from Canadian companies and capital gains receive special tax treatment outside of an RRSP but if they’re held within an RRSP this won’t happen. Any money earned in an RRSP is considered ordinary income when withdrawn. This ordinary income gets taxed at your marginal tax rate.
Withdrawals Will Impact Income Tested Benefits:
RRSP withdrawals can impact government benefits in retirement. This can lead to claw backs on OAS or GIS. Due to the high claw back rate on GIS (50%+) this is a BIG drawback for very low income families.
Contribution Room Is A Scarce Resource:
RRSP contribution room will never come back. Unlike a TFSA, if you make an RRSP withdrawal that contribution room is forever destroyed, you will not get it back the following year.
Contribution Room Is Based On Income:
RRSP contribution room is based on your gross income. In low income years you’ll accrue less contribution room. TFSAs on the other hand always accrue the same amount of contribution room regardless of income.
Less Flexibility To Share Available Contribution Room:
Spouses cannot contribute to each other’s RRSP. RRSP contributions can only be made using your own earned income. Making an RRSP contribution in your spouses name is a good way to get audited by the CRA and receive hefty fines/penalties. To get around this, it is possible for the high income earner to pay all the household bills/expenses which then frees up the spouses income to go towards RRSP contributions.
Mandatory Withdrawals At Age 72:
By the end of the year you turn 71 RRSPs must be converted to a RRIF which has prescribed withdrawal rates. These minimum withdrawals must be made regardless if you need the income or not. These withdrawal rates escalate each year until age 95 when they hit 20% of the balance. These mandatory withdrawals can create a tax burden that must be managed properly to avoid unnecessary taxes.
Tax Refunds Get Spent:
This is the BIGGEST drawback of RRSPs! If you spend your tax return rather than save it then watch out!
The most efficient way to use an RRSP is to make pre-tax contributions. If contributions are made with post-tax income then you get a tax refund when you file your taxes at the end of the year. This is a huge risk for many people who spend their tax return each year.
You pay tax when you eventually withdraw money from an RRSP so its very important that the tax refund you get today also gets saved. Otherwise you essentially get hit twice, once now when you spend the refund, and once again in the future when you pay tax on withdrawal.
This can cost you $100,000’s!
Using our example from above, spending the tax return will decrease the cumulative RRSP withdrawals by $291,473! Ouch!
RRSP – Spending Tax Return
Annual $3,517 Post-Tax Contribution, Tax Return Is Spent
$691,572 Cumulative Withdrawals (After-Tax)
[weblator_chart id=”28″]
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I have maxed my TFSA. I can not decide if I should use a taxable account or my RRSP. I make less than 40K per year but I save a lot of it.
I thought if I continued to make less than 50K per year that it would make sense to use my taxable account instead.
Hi Emily, this is an excellent question and the answer will very much depend on a number of different factors. At this income level the main concern we’ll have is planning around GIS benefits in retirement. I mentioned it in my post, but the claw back rate on income tested benefits like GIS can add up to 50% to 75%. This means that any RRSP contribution made before retirement may actually be cut in half upon withdrawal (or worse!) when we count these claw backs. Of course, there are strategies to help use an RRSP but “melt it down” quickly in retirement so an RRSP may still be an option, but it depends on your situation.
My advice would be to create a custom financial plan. Our plans start at $1,000. This is a significant fee on a $40k per year income but given the potential tax/benefit impacts I’m sure you’ll get a lot of value out of it. Our first meeting is free, so click “start planning” in the menu and complete the questionnaire and then we can discuss your situation in more detail.
Hope to hear from you soon!
Hello,
If you wouldn’t mind clarifying your statement regarding “Spouses cannot contribute to each other’s RRSP. RRSP contributions can only be made using your own earned income.” I would appreciate your help understanding this!
If I read the CRAs website correctly, spousal contributions if done correctly (not more than the RRSP deduction limit) are legal?
But I also thought, if both incomes were deposited into a joint account. Either spouse could then use that income to contribute it to their own RRSP? (not more than the RRSP deduction limit)
Thank you.
Hi Maurice, when using income splitting strategies is very important not to accidentally trigger income attribution down the road. This article explains some of the ways that income can be attributed back to the individual when contributing to a spousal-RRSP or when contributing to a spouses non-spousal RRSP.
https://www.advisor.ca/columnists_/wilmot-george/navigate-rrsp-attribution-rules/
One possible option in this situation would be to have the higher income spouse pay for most of the annual living expenses each year, this leaves the income of the lower-income spouse free to maximize their RRSP using their own income/funds.
Here is a blog post with some details on income splitting strategies for spouses…
https://www.planeasy.ca/different-ways-to-split-income-with-a-spouse/
Hi! I have a situation where I’m looking to retire early at 35. Does putting money into the RRSP still make sense? It feels like while I get the tax rebate, if I’m going to withdraw it at 35 anyways then I’d still take the 30% withdrawal fee and at that point it feels kind of pointless? Let me know if I’m missing something here. Thanks!
Hi David, thanks for the question, although we don’t know all the details for your situation it would likely make sense to use an RRSP.
First, one important clarification, the 30% withdrawal fee you’re referring to is the withholding tax and it is just a pre-payment of your income tax owing. Depending on the size of your withdrawal, your actual tax owing will likely be much lower, so you would get a refund after filing your tax return.
Second, the benefit of using an RRSP is that in early retirement you can trigger a certain amount of withdrawals from the RRSP, which counts as fully taxable income, and “use up” your basic tax credits. This type of strategic withdrawal planning would allow you to withdraw around $15,000 to $20,000 from the RRSP each year and pay very little income tax. You would contribute at a higher tax rate and withdraw at a very low tax rate (even 0% if you plan it perfectly).
Third, to reach financial independence and early retirement typically requires a lot of financial assets. Although a TFSA is great, it just wouldn’t be large enough yet to support FIRE at 35, so we would need to use RRSP contribution to tax shelter as much of the portfolio as possible.
I am in age 62 and my wife 59, last year we got our Canadian residency, do you thing that we can still contribute to RRSP or we consider TFSA as our future saving tool?
Hi Shahzad, that’s a difficult question to answer without a lot more information. It will depend on your income tax rate now and in the future. But without any additional information I suspect you would be better off starting with the TFSA for now. In the future these TFSA withdrawals would not impact your income tax or government benefits.
I don’t like the investments my job provides for RRSP Contributions, as such, I prefer to Hold a Self-Directed RRSP in Questrade.
I contribute 4% of my pretax pay check to maximize the employer matching benefit.
I then max out my RRSP using Post-tax income.
I’m afraid I didn’t understand the “tax refund gets spent” bullet point –> How do you get hit twice with taxes?
So, what you’re saying, is that we should put the tax refund straight back into the RRSP? What is the most tax efficient solution for me, if I don’t want to contribute more than 4% through my employer?
Hi Christian, its good to think about an RRSP as a “tax deferred” investment account and only a portion of the RRSP actually belongs to you (the rest belongs to the government for future tax). The tax refund you receive now will need to be paid back later when those funds are withdrawn from the RRSP. For that reason, if you’re contributing to an RRSP using after-tax dollars then you’ll need to invest the tax refund too, either back into the RRSP if you have room, or in a TFSA if you’ve maximized the RRSP. That tax refund can then grow to help pay for the tax when the RRSP is eventually withdrawn.
Hello and thank you for article.
At the beginning is mentioned that if a contribution is made with post-tax dollars, you get your tax back at the end of the year. I was not aware this is possible.
pre-tax => 10K => deposited in RRSP => reduces your income for the year by 10K
post-tax => 7K ( 10K – tax ) deposited in rrsp from my checking => reduces your income for the year by 7K.
I was under the impression that the 3K in tax is lost and not returned in any way.
Hi Bogdan, when you contribute to an RRSP you get a tax deduction that helps lower your taxable income on your tax return. This will help lower the amount of tax you owe and can create a tax refund. In your example it looks like you’re using a 30% marginal tax rate ($10,000 gross and $7,000 net income). With a 30% marginal tax rate, the $7,000 RRSP deduction will reduce tax by $7,000 x 30% = $2,100. Then if that $2,100 is also contributed to the RRSP it will create another tax reduction of $2,100 x 30% = $630. This can keep going. The net result is $10,000 in RRSP contributions, the same as putting in $10,000 gross into the RRSP. Hope that helps!
I see, it makes sense. The same tax is recovered just over a longer period of time. Thank you for the reply.
Hi, I am a resident of Quebec and I work for the United Nations so I am not subject to income tax on my salary. I don’t have other sources of income except my investments’ capital gains. Does it still make sense to contribute to a RRSP if I dont save on taxes now? TFSA is maxed out. Should I invest the surplus in an unregistered account or fill my RRSP first? When I retire, I expect my income to be below 50 000, probably even below 40 000.
Thanks!!
Hi Anna, that is a very unique situation and the best course of action will depend on a number of factors. This is probably a question that would need to be answered as part of a holistic financial plan. I would recommend working with an Advice-Only Financial Planner to determine if an RRSP really is a good choice in your situation.