Earlier this month I turned 30 🥳 and officially left my 20s behind. Going into the new decade made me reflect on my last 10 years and think about my future.
One of the things that I thought about was what I was working towards and retirement. We have all heard before how important it is to save for retirement and spend less but what does that actually look like?
Over the next few weeks I'll be talking about personal finance and breaking down different Canadian savings accounts that have special tax benefits like the RRSP, TFSA, and brand new FHSA.
Before we begin I want to make it clear that I am not a financial advisor and this is not financial advice. I cannot tell you what to do. Everyone’s situation is different. This is general information but I recommend consulting a certified financial advisor for their personalized recommendation. They will know your situation and be able to make a custom plan based on your goals.
To start us off today we're diving into the Registered Retirement Savings Plan or RRSP. This is one of the tools we have to help us in our journey of personal finance and retirement.
This type of account can be opened by any Canadian resident- even if you do not have permanent residency or citizenship.
I love RRSPs on a tax return for a few reasons.
You get a nice tax deduction which you can either use that year or save and carry forward to use in a future year.
It's the ONLY thing you can do to change/improve your tax return after the clock strikes midnight on January 1st and we enter a new year.
You can invest the money in your RRSP into stocks, bonds, ETFs, etc. and pay no tax on any of the gains, interest, and dividends you earn.
They can bump you into a lower tax bracket.
You defer the tax you pay on that money until you withdraw it later in retirement when you are (in theory) in a lower tax bracket.
The Tax Deduction & How RRSPs Work
Let's say that I made $60,000 of income during 2023. Normally I would need to pay tax on all $60,000 of that income. But let's say during 2023 I contributed $10,000 to my RRSP. For that RRSP contribution I would get a dollar for dollar tax deduction from the government. Which means I would only have to pay tax on $50,000 of income for 2023.
$60,000 of income - $10,000 RRSP deduction = $50,000 of taxable income.
RRSP contributions can even be used to bump you into a lower tax bracket in the year you contributed them.
In addition to the tax deduction you get, you can also invest the money in your RRSP in stocks, bonds, mutual funds, index funds, etc. In this way your money is able to earn more money than if it were just sitting in a regular savings account and you take advantage of compound interest. And the biggest benefit of this? You don't pay any tax on any of the interest, gains, and dividends that you earn inside your RRSP.
Essentially by contributing to your RRSP you defer when you pay tax on that money until you withdraw it from the account which is ideally in retirement. The benefit is that you are paying less tax on that money in the long run since your income is typically higher while you are working and therefore you're in a higher tax bracket. Then in retirement, when your income is lower, your tax bracket is lower as well. So instead of me paying 29% tax on that $10,000 in retirement I might only pay 15%! Plus you have all those years of tax free gains and compound interest working for you.
RRSP Contribution Periods and How They Benefit You
It's important to note that RRSPs don't run from January 1st to December 31st like everything else. They run from March 2nd of the tax year to March 1st of the current year. Or more accurately 61 days into the tax year until 60 days of the current year, so on leap years this changes. This means that after the clock strikes midnight on December 31st and the new year starts RRSPs are the ONLY thing you can do to change or improve your tax situation from the previous year.
For example let's say that you worked at 3 jobs during the year and each job individually took off enough tax but when you add them together into a lump sum not enough tax was deducted from the total amount. You didn't notice this until you got all your T4s in the new year but by that time it was too late to contribute more tax. However, it was still before the March 1st RRSP deadline so you were able to contribute to your RRSP which gave you a tax deduction and reduced your balance owing.
Limitations & RRSP Contribution Room
This sounds great but don't picture yourself jumping into a pile of money just yet.
There are some limitations. The government puts a cap on how much each Canadian can contribute to this special tax savings account. This is called your contribution room.
For your RRSP this is based on 18% of your earned income from the previous year up to a maximum of $30,780 for 2023. This amount typically increases year to year (2024's maximum is $31,560). If you do not use all your contribution room in a year it is carried forward and any new room is added to it. So let’s say your 2023 RRSP contribution room was $10,000 and you put $2,000 into your RRSP. You still have $8,000 of contribution room plus the new room from 18% of your 2024 earned income.
❗It's important to note that you must file a tax return to get your contribution room for that year.
What happens if you accidentally over contribute to your RRSP?
If you over contribute to your RRSP by more than $2,000 you need to withdraw your excess contributions as soon as possible and you will need to fill out a T1OVP form for each year you had excess contributions of more than $2,000 in your RRSP. There is a 1% penalty per month on the excess amount for each month you were over your limit.
What about if you withdraw money from your RRSP before retirement?
You're able to withdraw the money in your RRSP at any time. When you withdraw money from your RRSP you do not get that contribution room back. If you had $4,000 of contribution room in your RRSP and you withdrew $2,000 you would still have $4,000 of room. If you tried to recontribute that $2,000 to your RRSP it would count towards your contribution room and your contribution room would now only be $2,000. There are 2 exception to this rule and they are Home Buyers' Plan (HBP) and Lifelong Learning Plan (LLP).
What if you wanted some of the tax benefits an RRSP gives you but for short to medium time frames, or more flexibility to withdraw it without paying taxes or eating away your contribution room? That's what the Tax Free Savings Account is great for and I'll be covering that for you next week.
All the best,
Laura
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