What is an RRSP & How Does It Work?
Tax | August 31,2021
Registered Retirement Savings Plans provide an outstanding opportunity for Canadians to reduce their taxes and save for their golden years at the same time. In this post, we’ll discuss the RRSP rules and explain how you can maximize your benefits.
Why have an RRSP
Decades ago, the Canadian government recognized that people were living longer than ever and often did not have enough savings to last for decades of retirement. Officials came up with the RRSP concept to help Canadians put away money.
With average life expectancy now at almost 83 years, you will need a lot of funds to support you after you retire. An RRSP can go a long way to helping you save for retirement – and reduce your taxes along the way.
How does an RRSP work?
To open an RRSP, simply speak with your bank or financial advisor. You can contribute up to 18 percent of your previous year’s income, to a maximum of $27,830. So, if you earned $100,000 last year you can put in $18,000.
You receive a tax deduction for your contribution. When you file your income tax return, you get a credit that reduces your tax owing. This will likely generate a tax refund, which you can put to work by depositing it right into your RRSP.
If possible, it’s best to contribute automatically to your RRSP. Ask your financial advisor to set up regular withdrawals from your bank account – that way you won’t even miss the money. Even a contribution of $100 per month is a good start.
It gets better. As your investments grow, the funds accumulate tax free. You don’t pay any tax within your RRSP.
It’s only when you retire and begin making withdrawals that you will face a tax bill. However, the good news is that when you leave your job your income is usually reduced and you will be in a lower tax bracket.
What can I use my RRSP for?
Of course, an account is primarily a retirement savings vehicle. However, there are situations in which you can use the funds for other purposes:
- To buy a first home: You can withdraw up to $35,000 for a down payment on your first home. You must pay these monies back into your RRSP within 15 years or face a tax penalty.
- In an emergency: You can take out funds before you retire but you will be hit with a withholding tax. So, you can do this if absolutely necessary, but it’s a much better strategy to have a separate emergency fund in a savings account.
What happens when I retire?
There are several options for accessing your funds when you leave the workforce:
- Cash out: While this sounds tempting, it’s not usually a good idea because you will face a large tax hit on the withdrawal.
- Buy an annuity: An annuity provides you with a stream of income every month for the rest of your life. After you’ve passed on, the funds belong to the annuity company.
- Set up an RRIF: With a Registered Retirement Income Fund, you will be required to make minimum withdrawals every year. For example, if you start withdrawing money at age 71 you must take out 5.28 percent of the fund in the first year. If there are still funds in your RRSP at the end of life, your estate will receive the monies – less the tax payable.
If you would like advice on how to connect to a Financial Planner and what questions to ask – you can contact the ascentia team – We’d be happy to guide you in the right direction!
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