Financial Literacy Series: RRSP
What is the RRSP?
The first and most important thing to note about the Registered Retirement Savings Plan (RRSP) is right there in the name:
It’s a PLAN.
The RRSP is not an investment.
The RRSP is not a savings account.
You can’t put money in an RRSP.
You can’t buy an RRSP.
You can’t invest in an RRSP.
There is no such thing as “your” RRSP. You can’t own a government plan.
The RRSP is just a set of government rules and regulations that gives you incentives to save or invest money for retirement.
Confused? You’re not alone.
I would really like to clear up the confusion about the RRSP, so I’ll give you a quick overview and then have a closer look.
OVERVIEW OF THE RRSP
The Registered Retirement Savings Plan (RRSP) is a tax-deferred retirement plan created by the Government of Canada in 1957.
They decided to allow all working Canadians the ability to save or invest up to 18%* of the money they made (in the previous year) in most investment products or savings accounts. If you don’t use the full 18%, whatever you haven’t used gets added to the next year’s contribution room**.
This 18% would not be subject to tax, so it could be set up with an employer to be deducted before income tax deductions, or you could contribute after you paid tax, resulting in a tax refund. Additionally, any growth (interest or returns on investment) would be allowed to grow, tax-free until retirement.
Then, at the age of 71 (or earlier if you desire), you are required to convert any accounts that you designated as RRSP-type accounts into Registered Retirement Income Fund (RRIF)-type accounts so that you can withdraw money.
You are taxed on any withdrawals you make from your RRIF-type accounts, at whatever your tax rate is at that time. There are mandatory minimum RRIF withdrawals based on your age.
*It was only 10% until 1990. There is a maximum flat amount every year. In 2016 it was just over $25,000. This only applies if you make more than $140,000/year.
**Before 1990, you couldn’t carry forward any contribution room. It was “use it or lose it”. Canadians didn’t like that.
So that’s the overview. Now for a closer look at the 4 words in RRSP: Registered, Retirement, Savings, and Plan
The word registered means that it is something the government tracks. All RRSP agents, like banks or brokerages, are required by law to report to the government when you choose to designate an account under the RRSP.
It’s up to you to make sure that you aren’t telling a bunch of different banks and brokerages to register your accounts under the RRSP without first making sure that you aren’t exceeding your 18% annual limit, or accumulated unused contribution room from past years.
The RRSP agents aren’t there to take care of you. They just have to tell the government what you decided. Then the government adds it all up and gives you your tax refund.
But if you just go ahead and say all your accounts are RRSP-type accounts, and it’s more than you’re allowed, the government will charge you a penalty. So be careful and always check your contribution room before blindly calling everything an RRSP account.
As I mentioned earlier – you can’t buy an RRSP. It’s not a thing to buy. It’s a designation, or type of account. It’s not the account itself. It’s not the product.
Saying you invested in an RRSP is like saying you had “roasted” for dinner.
“Roasted” is just the type of chicken that you had.
You would actually say: “I had roasted chicken for dinner.”
You would never forget to mention the chicken.
The chicken is the product.
You can put money in a savings account (product) and then ask your bank to register that account as an RRSP-type account (you might do this before you open the account). The bank makes you fill out some paperwork and then they send it along to the government. If you already paid taxes on that money, you will get a refund on your taxes.
You can buy units of a fund or some stocks (product) through an investment company. You tell them you want the units or stocks to be considered part of your RRSP (type) contributions.
So the correct answer when someone asks where you money is invested is:
I own stocks of XYZ company. I asked my investment manager to keep the stocks in an RRSP-type account so I don’t have to pay taxes on their growth.
Just like you would say:
I had chicken for dinner. I roasted the chicken so that it tasted good.
Think of the RRSP registration of an investment product or savings account as a note that someone sticks on your investment product or bank account. The investments or savings then become registered and as long as you follow the rules of the plan, you’ll get the tax-deferral benefits.
The reason the word retirement is included is because the government wants you to know that the RRSP was specifically built for you to save for retirement. It’s not good for short-term investments due to the paperwork and withholding tax charged when you withdraw early. If you think for any reason you might need to use your money before retirement, please don’t use your RRSP room to invest that money.
Retirement, from an RRSP perspective, is when you stop working, or after you turn 71.
At 71, your RRSP magically(not really) turns into an RRIF and then you have to start cashing in your investments held in the RRIF-type account.
The mandatory withdrawal rate increases as you get older.
So unfortunately you now have to pay taxes, but because you are no longer working, your tax rate should be lower than it was before you retired.
And on top of that, it’s not like you have to go back and pay the taxes on all the interest and returns on investment from the last 30 years.
No, you just pay your current tax rate on any money “withdrawn” from the plan.
So if it’s all in a savings account, for example, you just make a withdrawal at the bank, and the bank reports that to the government and you pay taxes.
It’s that simple.
This one is a bit confusing because when most people hear “savings”, they don’t think “investments”. Though you can designate a savings account as an RRSP-type account, you probably shouldn’t.
The main benefit of the RRSP-type account is that the growth over decades is tax-free.
A savings account will likely have very low interest rates and the taxes will be very low as well. Unless you are a very risk-averse person and everything you have is in a savings account, there are other things that you should designate as taking up your 18% per year.
The general idea is that since growth is not taxed, you should fill up your 18% RRSP room with the highest-risk, highest-growth products you feel comfortable owning, and then leave them there for 30 years.
It’s important for people to not take the word “savings” to mean simply a savings account. What the government was trying to tell you is that they want you to not spend your money and save it, or invest it, instead.
A more appropriate title might have been Registered Retirement Investment Plan (RRIP), but maybe they didn’t like that RIP was in the title, from a marketing perspective.
This is how you know it’s a plan and not a product. But maybe calling it a plan is even too confusing. Program? Policy? Would anything in the name help clarify that it’s not a product to invest in and simply a government program?
At least the RRSP has the word “plan” in the name.
In this post, I talk about the younger sibling of the RRSP: the Tax Free Savings Account (TFSA).
Surprise – it’s not a savings account!