One of the big advantages of investing in registered retirement savings plans (RRSPs) is reduced income taxes. Here are several ways an RRSP can help you save for retirement while simultaneously saving you and your family tax.
A tax deduction upfront
The most immediate advantage people recognize when they make an RRSP contribution is the upfront tax deduction.
The amount you can contribute to an RRSP is based on a formula that allows for 18 per cent of earned income from the previous year, up to a maximum annual limit. The limit for the calendar year 2015, for which you can also contribute during the first 60 days of 2016 (up to Feb. 29), is $24,930.
If you live in Ontario, for example, and earned $100,000 of taxable income in 2014, you will be eligible to contribute $18,000 to your RRSP in 2015. At a combined federal-provincial tax rate of 43.41 per cent, that would provide you with a tax deduction of more than $7,800.
There is a caveat attached to the upfront deduction, however. When you ultimately start withdrawing the funds in your RRSP they will be taxed. Ideally, this withdrawal should not take place until your retirement years, by which time you will presumably be in a lower tax bracket compared to when you contributed the money.
Withdrawing funds for nonretirement purposes during peak earnings years could be financially costly.
"If you needed to withdraw the money sooner than initially anticipated, say three or four years down the road, there's a good chance that you may be in a higher tax bracket [than when you made the contribution]," says Graeme Egan, a financial adviser with CastleBay Wealth Management Inc. in Vancouver. "The withdrawal would be taxed at a higher marginal rate."
Accumulation of tax-deferred compound interest on investments
An RRSP offers plan holders the opportunity to enjoy tax-free compounding of income on investment instruments kept inside the plan.
For example, if you earn $1,000 in investment income and you keep that in an investment portfolio outside an RRSP, and are taxed at a combined federal-provincial tax rate of 40 per cent, you would pay $400 in tax and have just $600 in net proceeds left to earn compound interest. But inside the RRSP, the full $1,000 would be tax-sheltered as it grows in value, says Tom McCallum, a chartered professional accountant based in Whitby, Ont.
Some experts say investors should hold interest-bearing securities such as bonds or bond funds in an RRSP because interest is 100 per cent taxable, and they should hold stocks outside the plan, where they are eligible for capital-gains and dividend tax credits, says Robert Snowdon, a chartered professional accountant based in Ottawa's Kanata suburb.
But whether investors take this advice depends on a number of other factors, such as whether they have other registered accounts, including tax-free savings accounts (TFSAs), and non-registered accounts held outside an RRSP. Professional advice can help you determine the scenario that is most tax beneficial for you.
Spousal RRSPs can be used to equalize taxes for both spouses and thus provide considerable savings for the family unit. Higher-earning spouses can divide their RRSP contributions between their own RRSP and that of their spouse.
A spousal RRSP can also be used when a person older than age 71 – the age at which one must stop contributing to his own RRSP – is still working and earning income, provided his or her spouse is 71 or younger.
"If you have a 71-year-old-[plus] husband who continued to earn income, and a 65-year-old wife, the husband could contribute his RRSP contribution limit to his spouse's plan," says Mr. Snowdon.
A spousal contribution can also create pension income for the lower-income spouse during her retirement years that would be eligible for the annual federal and provincial/territorial pension income credit. The federal pension income credit is currently $2,000.
However, it is important to note that when considering a spousal RRSP arrangement there is an attribution period of three calendar years – the year you make a spousal contribution, plus two additional years – in which any income withdrawn from the RRSP by the lower-income spouse will be attributed back to the higher-earning spouse, and taxed at higher rates.
"One has to be very wary of that, and keep the three-year time frame in mind at all times," Mr. Egan stresses.
The only exception to that rule is if the lower-income spouse turns 71 and must terminate his or her RRSP, and it is rolled over into a registered retirement income fund, which has minimum annual withdrawal requirements.
After age 71
Although an RRSP must be terminated by the end of the calendar year in which you turn 71, RRSP plan holders have the option of converting their proceeds into either a registered retirement income fund (RRIF) or an annuity.
The RRIF offers plan holders an opportunity to continue accumulating tax-deferred compound interest with the same investments that were in the RRSP, except under a different set of rules. Plan holders will no longer be able to contribute funds. And they will be required, starting in the year they turn 72, to withdraw a mandatory minimum percentage of their RRIF proceeds and pay tax on that amount.
"From a tax standpoint, it is hoped that your overall tax rate is lower during those years when you're age 72-plus, even though you may be receiving CPP and OAS, and maybe other pensions," Mr. Egan says.
If the overall tax rate is lower at retirement than when you were contributing funds to the RRSP, that really cements the long-term benefit of having had tax deferred compounding within the RRSP over the decades, he stresses.
The 2015 federal budget reduced the minimum annual RRIF withdrawal to reflect today's low-inflation environment and lower rates of investing return. At 72, RRIF plan holders must now withdraw 5.28 per cent of their plan's balance, down from 7.38 per cent previously.
The minimum percentage to be withdrawn increases each year. For example, it is 6.58 per cent the year you turn 80, and 10.99 per cent when you turn 90, up to a peak of 20 per cent when you turn 96.
"You don't have to draw out as much money. There's a tax advantage there," says Mr. Snowdon.