The Registered Retirement Savings Plan (RRSP) is a common type of investment account that many Canadians use to help save for retirement. While the RRSP is often the first choice for many investors who plan to save, the advantages and disadvantages are often misunderstood. Before investors make their contribution, it is worth considering their unique circumstances and whether the RRSP is the best choice.
The biggest advantage of the RRSP is that deposits may help reduce taxable income for the year. This is particularly beneficial for income earners at the highest tax brackets. Investors may make an RRSP deposit with the idea of bringing their income below the highest percentages of taxation. This strategy may result in immediate tax savings and/or a tax refund.
While most investors agree that paying less tax is a sound concept, one must consider what happens when it’s time to spend the funds in an RRSP during retirement. Simply put, any funds that come from a RRSP or a Registered Retirement Income Fund (RRIF) are added to an investor’s taxable income. Therefore, while the advantage is that the funds can save one tax at deposit, the disadvantage is that the funds are then again taxable at withdrawal.
If this strategy is done properly, the hope is that RRSP deposits were made when an individual was in a higher tax bracket and then withdrawn when the individual is in a lower tax bracket.
Another benefit of the RRSP is that all growth and income is deferred from taxation. This means that the deposited funds can grow untaxed for years until it’s finally time to use the funds for retirement income. Again, the hope here is that RRSP deposits grow notably over decades, and then will provide a foundation for retirement spending.
With this in mind, it is still possibly true that the RRSP may be a benefit to investors who deposit funds at the same tax bracket they face at withdrawal. The point is that the funds were allowed to grow untaxed for years which creates a larger compounding effect and therefore a larger source of withdrawal during retired years, even if the tax rate is the same.
Ideally, an RRSP should be used by a high-income earner who doesn’t expect their retirement income to be as high. Conversely, the RRSP should be used by an investor who is needing an account to offer a deferral of taxation of their investment growth. Combined, both of these concepts make the RRSP a useful account.
With the introduction of the Tax-Free Savings Account (TFSA), it’s possible that some investors would be better off or have similar results by using a TFSA versus an RRSP. In this case, a TFSA offers no immediate tax benefit at deposit, but the account may grow for years tax-free. Furthermore, at withdrawal, the TFSA allows for tax-free withdrawals, meaning the income is not included.
Some investors understand this concept and ‘double dip’, meaning they firstly invest in their RRSP at the higher tax bracket and then when they receive their tax refund, they turn around and reinvest those funds back into their TFSA and/or RRSP again and so on. In this case, they are taking the tax savings and earning interest tax-free or tax-deferred for multiple years.
Finally, if an investor is in a zero or low tax position for a year, there is little advantage to using the RRSP, especially over a TFSA. In this example, funds would go to the RRSP. There wouldn’t be any tax savings and then at withdrawal, the funds become taxable at a potentially higher tax rate particularly if other government benefits such as the Canadian Pension Plan and Old Age Security (OAS) are now received. In this example, an investor could potentially lose funds by investing in an RRSP merely from a tax perspective.
The deadline for RRSP contributions to apply for the 2022 tax year will occur on March 1, 2023. If you need further advice as to whether an RRSP contribution is right for you, please contact a qualified Wealth Advisor and professional tax specialist.
Derek Fuchs is a Senior Wealth Advisor and Portfolio Manager with Scotia Wealth Management based in Red Deer. He writes this column to help educate and inform local investors. Have a question? Email Derek at derek.fuchs@scotiawealth.com anytime.