Canadian Registered Savings Plans
Registered Savings Plans, Tax Advantaged Accounts, Tax Sheltered Accounts, they go by many names but they all mean the same thing: Registered accounts that have tax advantages. Canada has a few different types of Registered Savings Plans that typically have tax benefits for the users. The two main accounts are the Registered Retirement Savings Plan (RRSP) and the Tax Free Savings Account (TFSA). There are also others like the Registered Education Savings Plan (RESP) and the Registered Pension Plan (RPP), but we’ll talk about those later. While the name implies that these accounts are for savings, it is very important that the money saved in these accounts is also invested. Popular investment methods for these accounts are Mutual Funds and/or ETF’s.
Registered Retirement Savings Plan (RRSP). This account is a tax deferral account. That means the money you put into it is not taxed until you take it out. Defer means to postpone, so deferring taxes means to postpone taxes. If you put money into the account that has already been taxed, it can result in a big payout around tax time because you will get the taxes you already paid on that money back.
Example: If you make $100, after taxes you might have $70($100 taxed at 30% would leave you with $70). If you put the $100 in before it is taxed, you will not be taxed until after the money comes out of the account. If you put $100 that has been taxed, you will get $30 back at tax time.
What are the benefits of this? You get to invest more.
If you invest $100 into an RRSP, the initial tax on the $100 of income is postponed, so you get to invest all of it. Lets say you get a 10% return ($100×1.1 = $110), and then pull it out. Upon withdrawal, you are taxed 30% ($110×0.7). This leaves you with $77.
If you invest $70 in a regular account ($100 taxed at 30% because a regular account doesn’t defer taxes, $100×0.7 = $70) and get a 10% return, you will end up with $74.9 ($70 + the income from the 10% return ($7 also taxed at 30% = $4.9)). Using the RRSP in this case increased the amount of money you had at the end by 2.9%. This number goes up the longer you have it invested due to compounding. Let’s see how much of an effect compounding has in the next example.
In the RRSP example, we had $110 before withdrawing after the first year. If we do not withdraw that from the account, we still have $110. A 10% return now gives us $121 ($110×1.1 = $121). Taxed at 30% on withdrawal, we are left with ($121×0.7 = $84.7). $84.7.
The regular account was left at 74.9. With a 10% return, it is now (74.9 + the income of the 10% return ($7.49 x 0.7 for the 30% tax) = $80.14.) $80.14. ($80.14/$84.7) x 100 – 100 = 5.38% difference between the two – an increase over the 2.9% from the first year. I’m sure you can imagine the benefits over 25-30 years!
Another way to use the RRSP to maximize gains is to put money into it when you are in the highest tax bracket you think you will be in. So if you are in a higher bracket and don’t plan on using that money until retirement (when you will be in a lower bracket due to losing the income from your job), you could get a decent return without even counting investment returns.
Example: A man with a wage that puts him in a tax bracket of 40% puts money into his RRSP. Years later he retires, with only his investment and pension income, he is now only in the 15% bracket for his earnings. When he pulls money out of his RRSP, it will be taxed at 15% instead of 40%. that is a gain of 25% simply by timing when you use the account.
Money in an RRSP is still fairly accessible, the only downside to withdrawing it is that you will have to pay tax on the money you take out, and the room in the RRSP is lost. What do I mean by room? RRSP’s have a cap on the amount of money you can contribute to them. in 2020, the additional contribution room you can add to your RRSP is 18% of your annual income, up to $27,230. This contribution room is split with RPP’s (mentioned below). This number does roll-over, you do not lose it if you don’t contribute. You can see how much contribution room you have available by logging in to your CRA account. There are certain ways to remove money from your RRSP without losing the contribution room or having to pay tax. The first time homebuyers plan is one of those ways, however you do have to repay it over a certain time period.
Pros and Cons
Tax Free Savings Account (TFSA). This account works in the opposite way of the RRSP. You put in after tax money, but none of the income is taxed.
Example: Using the same numbers from the RRSP example, you have $100 taxed to $70. It then makes a 10% return, but this time the income is not taxed. $70 + (10% of $70 = $7) = $77. You end up with the same amount of money as investing the $100 into the RRSP! TFSA’s also have a contribution limit – much less than the RRSP. Every year after you turn 18 in Canada, you are able to contribute an extra amount specified by the government. This amount does roll-over to the next year, you do not lose it if you don’t contribute. In 2020, the additional contribution room for TFSA’s was $6,000. That is less than a quarter of the maximum possible contribution room for the RRSP! Money in a TFSA is more accessible than the RRSP because it is already taxed and the contribution room comes back at the end of the year. So if you take $1000 out of your TFSA, you can put it back in next year. This is better than the RRSP where contribution room is lost when removing funds, unless you are using special programs like the first time homebuyers plan.
While the TFSA and RRSP are the most popular tax advantaged accounts, there are others. These include the Registered Education Savings Plan (RESP), Registered Disability Savings Plan (RDSP) and the Registered Pension Plan (RPP).
An RESP is a registered savings account that allows for people to save for the educational expenses of someone in their care, typically their children. The contributions to the account are not tax free. The income generated inside the account is tax free, unless the money is not used by the beneficiary. If the income is returned to the original contributor, tax must be paid on the income generated by the account. Another big advantage to this account is that the government offers grants to encourage families to contribute to an RESP. The Canada Education Savings Grant (CESG) is one of these grants. Money from an RESP is paid out in educational assistant payments (EAP’s).
An RDSP is a savings account intended to help guardians of people that are eligible for the disability tax credit save for the long term security of this person. Contributions to this account are not tax free, and income generated in the account is taxed after being withdrawn. This account does not provide great tax advantages and is primarily for assisting with the long term care of disabled family members.
RPP’s are retirement plants usually set up by an employer. Contribution room for the RPP is shared with RRSP’s. Example: If you have a contribution room of $100, you could put in $50 to an RRSP and $50 to your RPP. This would use up your total limit. Because this account uses contribution room from RRSP’s, it follows many of the same rules: contributions and income are tax free until they are withdrawn. Withdrawals are much more difficult than an RRSP, however. Funds are typically locks in until retirement. Sometimes exceptions can be made if the account holder undergoes certain life changing events.
For more information, view the Government of Canada website