Investing Basics - RRSP

This is the first in a series of posts of the basics of investing.

A Registered Retirement Savings Plan, or RRSP, is a common way Canadians save for retirement. It was introduced by the federal government in 1957 as a measure to boost the savings rate of Canadians.

As we close in on the deadline for RRSP contributions, many people wonder if they should contribute to their RRSP, and if so, how much they should contribute. I am hoping to equip you with the information you will need to make an informed decision and get the most out of your retirement savings.

What is an RRSP?

An RRSP is a vehicle you can use to get an immediate tax deduction and defer tax on the income and gains earned on your investments. It is not until the funds are withdrawn that you pay tax on the amount withdrawn. An RRSP is not investment in and of itself. Most investments available at your financial institution qualify for RRSP purposes. You have to choose which investments you want to hold when you make an RRSP contribution, whether it be stocks, bonds, mutual funds, GICs, or just hold it in cash.

The idea with an RRSP is that you contribute to your RRSP when you are in your peak earning years and get a deduction when you are in a high tax bracket. Then when you retire and withdraw the funds from your RRSP, at which point they are taxable, you may be in a lower tax bracket. For example, if you earn $80,000 during the years you contribute to your RRSP (36.5% marginal tax rate based on 2008 combined Federal and BC rates) and have a retirement income of $50,000 (30% marginal tax rate), you will have a net tax savings of approximately 6.5%. In addition, you defer the taxes you pay on the growth earned within the RRSP.

Contributions made to an RRSP are tax deductible. Any contributions you make between March 1, 2008 and March 2, 2009 can be used to offset your 2008 income for tax purposes. If it is not beneficial for you to deduct all of your contributions in that year, you can carry them forward to a future year to reduce your income.

How much can I contribute?

RRSP Canada Revenue Agency, or CRA, sends you a Notice of Assessment each year once they have taken a look at your tax return. The amount you can contribute to your RRSP is on that notice. If you have previously contributed to your RRSP and did not deduct the amount in prior years, you cannot contribute as much as it tells you (subject to a lifetime $2,000 overcontribution limit). If you overcontribute to your RRSP and put more money in than CRA says you can, you have to pay penalties and withdraw the funds.

Your RRSP room is calculated as 18% of your earned income from the prior year, subject to various adjustments, such as pension adjustments if you are a member of your company’s pension plan.

Should I contribute to my RRSP?

For the average person, it makes sense to contribute to your RRSP. Keep in mind that even if you are in a low tax bracket, if you expect to earn more money in the next few years, you can still contribute to your RRSP, but you do not have to deduct it from your income. Any contributions made to your RRSP will grow tax-deferred whether you deduct them from your income or not. Keep in mind that if you want the tax deduction now but don't want to think about how to invest your contribution, you can keep it in your RRSP then decide what to do later.