In 1956, the Canadian government determined that population growth would put pressure on current retirement programs. In order to encourage people to save for their retirement, the government created the Registered Retirement Savings Plan (RRSP). RRSPs have been a staple of financial planning in Canada ever since! Do you know the RRSP basics?
Most Canadians cannot answer questions like 'what are RRSPs, and when should i use them, or not use them'? There are advantages to having an RRSP. There are also a couple of potential disadvantages that come along with those benefits. After all, nothing is free, even if it seems to be a good deal!
A Vehicle for Deferring Taxes
The basic value provided by an RRSP is tax deferral. If you haven't read it already, read our intro to the Canadian Tax System here. It is
critical to understand progressive taxation in order to understand the value of an RRSP. If you get lost in the next few paragraphs, please go back and reread that article.
The one advantage of using an RRSP is to put money into the plan when our marginal tax rate is high, then take it out during a year where our marginal tax rate is lower. If you take the money out of your RRSP when your marginal tax rate is the same as when you contributed the money into the plan, there is no significant benefit from the RRSP. You would have been better to put the money into a TFSA.
Here's an example with simple numbers. Suppose we contribute to our plan when the marginal tax rate is 35%, and withdraw it later at a marginal tax rate of 25%. The owner of the plan will have increased retirement cashflow by 10% compared to investing the same way outside an RRSP or TFSA. This 10% increase may be worthwhile for some RRSP plan holders, and not for others.
Let's look at someone who is 4 years from beginning to draw from the RRSP,. The one time 10% increase represents 2.4% per year additional income. But for someone 20 years from using it, the RRSP only adds 0.48% per year.
How can I Invest My RRSP
Many different investments can be contained within an RRSP, so long as they comply with restrictions stipulated in the Income Tax Act. Qualified investments include
savings accounts, GICs, bonds, mortgage loans, mutual funds, income trusts, common and preferred shares listed on a designated stock exchange, exchange-traded funds, call and put options (including some covered calls) listed on a designated stock exchange, foreign currency, and labour-sponsored funds.
The maximum annual allowable contribution to an RRSP is limited to 18% of the previous years taxable income. There is also a maximum limit set annually by the government. That limit for 2024 is $31,560 - limiting only those with incomes above $175,000. Unused contributions can be used in future years ("carried over").
What's the Catch?
The RRSP does a terrific job of deferring taxes into the future, but eventually, the government wants their tax money! At the end of the year in which the holder turns 71, the holder has 3 options. The RRSP must be converted into a registered retirement income fund (RRIF), an annuity, or closed (meaning the withdrawal of all funds within the RRSP). The conversion can occur earlier - as early as age 61. Once conversion takes place, the government mandates that a minimum percentage of the account must be withdrawn every year. The minimum percentage is based on the holder's age. This withdrawal MUST occur, no matter the tax consequences of that withdrawal. Locked in retirement funds (LIRAs), when converted also have a maximum withdrawal percentage allowed annually.
This lack of financial flexibility is one of the major drawbacks to an RRSP. As a result financial planners have developed RRSP meltdown strategies. These strategies speed up the removal of RRSP funds while minimizing the tax burden. Most of these strategies involve generating or using tax losses to offset the income caused by the increased RRSP withdrawal.
Are There Better Options to an RRSP?
For some people TFSAs and certain life insurance products may be better options. These offer benefits even while the holder is still earning significant income.
Young people starting out on careers where the expectation is for significantly higher earnings in the future should be considering maximizing their TFSAs first, before contributing to an RRSP.
The lowest federal income tax bracket in Canada is for those with incomes less than $57,375. If you income is below this level, contributing to an RRSP is likely to be a false economy. Your RRSP converts Capital Gains into regular income. If your investments return more than inflation you will be paying more taxes in the future than you are saving now.
Summary
Every individual's situation is different! This is why we strongly recommend that Canadians work with an industry licensed practitioner to put together a plan.
That's the basics. We cover some strategies for using RRSPs in another post, see RRSP Strategies, 
