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What you need to know about RRSPs

by | Feb 8, 2023 | SELF-PUBLISHED

How much you can contribute, what investments you can hold

For most Canadians, a Registered Retirement Savings Plan (RRSP) is still the single best way to grow a retirement nest-egg while deferring taxes. In fact, it is such a powerful retirement savings vehicle that most average wage earners can use it to retire with a million dollars. That’s because an RRSP lets you contribute a maximum of 18% of your “earned income” every year (less various “adjustments” related to pensions) to a pre-set maximum. For 2022, the maximum contribution limit was set at $29,210 (and because the contribution limit is indexed, it climbs to $30,780 for 2023). 

The last day to make a contribution to get a deduction for contributions made in the 2022 tax year is March 1, 2023. In addition, you can carry forward any unused contributions from 1991 on and use them as well. You also get a tax deduction on your contribution for a given year. 

Your investments grow tax-free inside an RRSP. You don’t pay tax until you withdraw funds from your RRSP at retirement, and then you pay tax on the withdrawals at your full marginal rate. But that will typically be lower than during your peak earning years.

Check your last Notice of Assessment from the Canada Revenue Agency to see what your contribution room currently is. 

Your maximum contribution to an RRSP is calculated as the lesser of 1) 18% of your earned income from the prior year, or 2) the maximum contribution limit for the tax year, or 3) the limit after deducting company pension plan contributions. “Earned income” includes your salary, but may also include alimony payments and rental income, but not investment income.

If your tax deduction results in a tax refund, reinvest the refund in your RRSP right away to keep that compound growth working for you. If you begin at age 40, and contribute, say, $20,000 per year for 25 years, at an average annual compounded 8% rate of return, you’ll retire with $1.7 million.

Carry forward contribution room

Many people are unable to make the maximum RRSP contribution in a given year. If so, the rules let you carry forward the missed contribution indefinitely as extra contribution room for future years. Your unused contribution limit is also shown on your CRA Notice of Assessment. 

The carry-forward feature may be especially useful for those who expect to be in a higher tax bracket in future years.

RRSPs may hold a wide variety of investments, including mutual funds and exchange-traded funds, stocks, bonds, GICs, and more. A complete list of qualified investments is shown on the CRA website.

Borrowing your RRSP contribution

It seems like the best of all worlds. You’ll get a tax deduction on the contribution, you’ll be able to pay down the loan with your refund, and your investment could well earn more than the interest on the loan. But there are a some downsides.

The biggest is that you are leveraging your investment. It makes no sense to put borrowed money into a safe, interest-bearing investment like a GIC, because it earns less than the cost of your loan. But if you invest in equity investments, either directly by purchasing stocks or through a mutual fund or ETF, you run the risk of magnifying any losses that may occur. In other words, the value of your investment may end up being less than the value of your loan. Another minus is that you don’t get to deduct interest on loans used for RRSP contributions.

Remember, too, that an “RRSP loan” is still a loan – a debt with interest payable. And you must make the payment to the lender when it’s due, regardless of what happens to your RRSP investment or anything else. 

The RRSP portfolio

Finally, when choosing investments for your RRSP, keep in mind the purpose of the plan.

For many of us, an RRSP is our only source of retirement income apart from the Canada Pension Plan. And while you can invest in just about every type of asset class, an RRSP not the place to speculate on things like junior mines, high-tech start-ups, commodities, or other risky and volatile assets. Remember, tax benefits like the dividend tax credit, the capital gains tax exemption, and the ability to offset losses against gains are lost within an RRSP.

Aside from not contributing to an RRSP at all, the RRSP investment choice is where most people go astray. Most of us tend to overestimate our capacity to deal with market volatility and take investment losses. So be realistic about your own tolerance for risk. Work with an objective financial planner to allocate your RRSP assets according to a plan determined by your personal goals and a realistic assessment of your tolerance for risk.

© 2023 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice.

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