What Is an RRSP and How Does It Work?

There are many mysteries in life, for example, what exactly is gluten? We all have holes in our knowledge that we’re embarrassed to admit but if your client is still unsure about what an RRSP is and how it works, now might be a good time to have that conversation.

Using an RRSP doesn’t have to be complicated or intimidating. In fact, once you break it down for your client, they’re pretty straightforward. Even better? Teach your client how RRSPs work, encourage them to open one, have them start contributing and feel confident knowing that they will benefit from this in the future.

So grab a coffee refill and carve out ten minutes to review all that your client needs to know about RRSPs. Then, share the client-friendly version of this article with them via the link at the bottom of this blog.

What is an RRSP?

RRSP stands for Registered Retirement Savings Plan. An RRSP is an investment account that your client can contribute to each year in order to build up long term savings, most often for retirement (as the name suggests).

How an RRSP works

The most important way an RRSP differs from a regular (non-registered) account or a TFSA (Tax-Free Savings Account) is how it’s taxed. Your client’s RRSP contributions are tax deductible. So, when they contribute to an RRSP, they pay less in income taxes than they would otherwise. And while the money is in their account, it grows tax free. Later, when they withdraw that money again — typically in retirement — they pay taxes on it as though it’s income.

Lifecycle of an RRSP

Step 1: Earning money

Chances are, your client has already started this step. If they work for someone else, their employment income tax is taken off their paycheque automatically. If they work for themselves, they’ll pay those taxes either annually, or on a quarterly basis, depending on how much money they make.

Step 2: Opening an RRSP 

Once your client opens an RRSP, they’ll be ready to contribute assets. They should consider their RRSP like a box in which they can place their cash and different types of investments. These can include publicly traded stocks, bonds, ETFs, mutual funds, or GICS — just about any financial product that holds value.

Because your client is almost certainly saving for the long-term, (retirement being the end-game), it’s wise for them to take advantage of the opportunity to grow the value of their account by investing the money in the account.

Step 3: Contributing money

Each year, your client can contribute 18% of their previous year’s earned income, or the year’s maximum contribution rate, to their RRSP — whichever is less. For the 2021 tax year, the RRSP contribution limit is $27,830. Also, if your client didn’t max out their contribution room in previous years, that amount carries forward to the present.

To maximize savings, your client should consider setting up automatic contributions so the money is automatically taken out of their chequing account on a recurring basis.

Step 4: Using the RRSP money 

Your client now has the option to withdraw money from their RRSP before they retire. Generally, we strongly advise against making early RRSP withdrawals because they’ll be hit with severe tax penalties — unless they plan to take advantage of the Home Buyer’s Plan or Lifelong Learner Plan. Even then, there may be better ways to get funding.

Step 5: Converting an RRSP to a RRIF

Once your client retires, the money in their RRSP becomes retirement income. To make these withdrawals, they’ll need to convert their account into a RRIF (Registered Retirement Income Fund). Your client will need to do this by the end of the year that they turn 71, but they have the option to do so sooner.

Any money they take out at this stage will be taxed as income when they withdraw it.

One Extra Step: Managing the estate

When your client passes away, their spouse can inherit their RRSP. If they don’t have a spouse, any beneficiaries they name receive it as cash. If your client hasn’t named beneficiaries, it gets rolled into their estate.

RRSP tax benefits

So where will your client see the benefits of contributing to their RRSP? In the form of tax savings! In fact, when people talk about RRSP contributions being “tax-deferred,” they mean that one can save on taxes now, and pay them later.

Your client can expect to save 30 to 40 cents on the dollar in tax when they make contributions to their RRSP. This RRSP tax savings calculator can help you determine your client’s tax savings of an RRSP contribution — the exact amount depends on their marginal tax rate which is determined by income and differs by province. When they withdraw that money in the future, they’ll pay taxes on it equivalent to their tax bracket at that time. Generally, your client can expect their income in retirement to be lower, so they’ll pay less taxes.

RRSP vs. TFSA: Which is right for your client?

As you know, RRSPs and TFSAs (Tax-Free Savings Accounts) are both excellent options for long-term investing, and both offer tax advantages.

Like the name suggests, the RRSP is typically going to be the best option if your client is investing specifically for retirement. That’s especially true if they’re in their peak earning years.

With a TFSA, your client won’t benefit from any income tax savings upfront, but when it comes time to withdraw the money from their account, they won’t pay any taxes, even on interest and investment growth. If your client thinks their income will be higher in retirement than it is now, or if they want to ensure that the money’s available for any purpose, not locked away until retirement, then a TFSA might be the best bet for them.

Check out our detailed comparison of TFSA vs. RRSP and share this with your client.

Spousal RRSPs

If your client is married, they can set up a joint RRSP for themselves and their spouse. This can come with several benefits. If one of them earns more than the other, they can make a larger contribution and benefit from the tax break — while they’re both able to withdraw the money later.

In that case, if the spouse with the lower income withdraws the money, it will be taxed at their tax rate. This maximizes savings for both spouses. However, there are some requirements that your client needs to meet — such as making sure the spouse with the higher income doesn’t make a contribution the year before the withdrawal.

How a Spousal RRSP Can Benefit Your Client will help outline how your client and their partner can make the most of a spousal RRSP.

The 2022 RRSP contribution deadline

The deadline to contribute to an RRSP for the 2021 tax year is March 1, 2022, so be sure to let your client know today.

For more information on RRSPS and how they can empower your client in their retirement, contact PPI’s Wealth Management team.

Excerpted from CI Direct Investing blog and reposted with permission.

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What Is an RRSP and How Does It Work?