Understanding Your RRSP
First Published: ADawnJournal.com May 22, 2010
Retirement is approaching for the Baby Boomers and that has many thinking about their RRSPs. Many Baby Boomers have been contributing to their RRSP for many years now, but how many actually know what is going on with their RRSP? Do you know about contribution limits? Do you know when you need to start taking money out of it, or what RRSP even stands for? Well, now that you are approaching the age of retirement, its time to learn more about the world of the RRSP.
RRSP, or Registered Retirement Savings Plan, is an account that provides you with tax benefits for saving for your retirement. Only available in Canada, it was created as part of the Income Tax Act that was created to give you the ability to shelter your financial property from income taxes. The ways that you can reduce your taxes with an RRSP come down to three options:
1. RRSP contributions are deducted from your income before your income tax calculation is due.
2. Income that you earn with your RRSP is not taxed until you withdraw money from the plan, which gives your account the ability to grow faster than if you were making contributions outside the plan that are subject to taxation.
3. You can withdraw from an RRSP in tax years when you are in a lower-income tax bracket due to unemployment or other circumstances.
You can hold a variety of financial properties within an RRSP, in many more options than other retirement plans of other countries. Some of the financial properties include a savings account, guaranteed investment certificates, bonds, mortgage loans, mutual funds, shares, labor-sponsored funds and income trusts.
The Types of RRSP
There are three main types of RRSPs that you can choose from depending on your life circumstances.
1. Individual RRSP: This is an RRSP that is meant only for one person, who is the account holder of that RRSP. Only the account holder can contribute money towards the RRSP.
2. Spousal RRSP: With this type of RRSP, the higher earner, who is the spousal contributor, can contribute in the name of their spouse. The spouse is the account holder and the spousal RRSP is the way that an RRSP is turned into split income for retirement. When investment properties are divided between the spouses, each spouse gets half of the income. This creates a lower tax rate than if one spouse earned all of the income. If there is $300,000 in the RRSP and one person has it, the tax rate is higher than if two spouses have $150,000 each from it.
3. Group RRSP: With this RRSP, an employer has employees making contributions through deductions from their pay checks. The employee can then decide the size of the contribution each year and the employer will deduct a certain amount accordingly for them. This is then deposited into the individual account and invested as the employee wants.
While the Group RRSP is held in only one account structure, Individual RRSP and Spousal RRSP accounts can be held in one of three account structures.
1. Client-Hold Accounts: This is when the account holder uses their RRSP to purchase an investment with a certain investment company. Each time an individual uses money from the RRSP to purchase an investment from a different company, a separate client-held account is then opened. For example, if you buy investments from Fund Company 1 as well as Fund Company 2, you will have two separate RRSP accounts held with those two companies. You do not generally have annual fees with this type of account but it is harder to keep track of your RRSP in this structure.
2. Nominee Accounts: These accounts have the individual account holder nominating a nominee for their account and this is typically one of the major banks in Canada. This nominee will hold the different investments in a single account for the account holder. So, if you have investments with Fund Company 1 and Fund Company 2, it will be held within a single RRSP account with the nominee. The benefit here is that it is easier to keep track of your RRSP investments, but you do incur annual fees.
3. Intermediary Accounts: These accounts serve the same function as nominee accounts and the reason someone would choose this over a nominee account depends mostly on the investment advisor the person deals with. If the investment advisor is not aligned with a major investment company or bank, they may not have the logistical ability to offer you nominee account options. The advisor will therefore approach a company to offer the investor identical benefits as those that come from a nominee account. The main benefit and disadvantage to this is the same as you would find with nominee account.
Contributing To RRSP
As with most investment retirement plans, there is a maximum amount of money that you can contribute in any given year. This amount is how much you can contribute without being taxed, as in the amount is completely tax deductable. Typically, it comes to 18 percent of your earned-income from the previous year minus a pension adjustment up to a certain maximum. That maximum does change over time.
Here is a brief rundown of just how much the maximum has changed over the past six years:
· 2004: $14,500
· 2005: $16,500
· 2006: $18,000
· 2007: $19,000
· 2008: $20,000
· 2009: $21,000
· 2010: $22,000
When you file a tax return, you will receive a Notice of Re-Assessment from the Canada Revenue Agency that indicates just what your new RRSP deduction limit is going to be.
This is where we come to the biggest advantage of the RRSP. With your RRSP, your contributions are completely deductable from your income. That deduction is based totally on your tax bracket and the amount of tax paid on the last dollar of earned income. So, if you are in a marginal tax bracket of 40 percent, then if you contribute $1,000, you will receive $400 back in your taxes.
You can contribute to your RRSP until the age of 71. At this point you must cash it out or mature it into a Registered Retirement Income Fund.
A last point on RRSP contributions is that if you contribute within the first 60 days of the tax year, you must report those contributions on the previous year’s tax return, but you may also deduct those contributions fro the previous year.
Withdrawing RRSPs
You can cash out any amount from your RRSP at any age, but when you withdraw money from your RRSP, that is counted as taxable income and you will pay taxes on it. As was already mentioned, once you hit the age of 71 you must cash out your RRSP or transfer it to a Registered Retirement Income Fund. Before 2007, the age was 69 but the rising number of Baby Boomers still working resulted in the RRSP age limit to change by two years.
RRSP Myths
Many RRSP investors say that if you want to retire in a nice style you need to start contributing to your RRSP when you are young. For example, if you begin to contribute to your RRSP when you are 22, and you put in $4,000 every year, with an eight percent annual rate of return, you will have $1.3 million when you retire. So, naturally the longer you have the better it seems for your retirement savings. However, there are some common problems with this concept, the first being that there are not too many 22-year-olds who are going to be able to afford to put $4,000 away, or want to, for something that is 43 years away. Most people do not start contributing into their RRSPs until they are in their 30s. The older you get, usually the more you can contribute. If you contribute $4,000 a year from the age of 22, you can reach $1.3 million, but you can also contribute an extra $4,000 fro the age of 42 to 65 to make up the same difference. Not to mention, the earlier you invest, the more you pay in commission and fees. If you do not start putting money into your RRSP until you are 42, you save on 20 years of annual fees that you would have paid into if you started at the age of 22.
Another common myth is that you should borrow if you do not have the funds to contribute to your RRSP. This is not a good thing to do. Borrowing to invest only makes sense if the annual rate of return is higher than the amount you will be paying in interest on the loan. If you are paying an interest rate of six percent and only getting an annual rate of return of four percent, then you are losing money, not making money.
