The Registered Retirement Savings Plan (RRSP) is a tax-sheltered account created in 1957 to help Canadians save for retirement. For my American readers, an RRSP is similar to the traditional IRA.
In this article, I'm going to review everything Canadians need to know about RRSPs
What is an RRSP?
Let me start by explaining what an RRSP is not, which is an investment. Despite what some people believe, an RRSP is simply a type of investment account and not an actual investment.
Contributions into an RRSP are made with "After-tax income". That means you can deduct the amount you contribute to an RRSP against your taxable income. This effectively means you do not pay tax on the contributions you make into an RRSP.
Any investments you hold inside an RRSP are allowed to grow tax-free until you withdraw them. That makes RRSPs a fantastic account to hold stocks and bonds.
Any withdrawals you make from an RRSP are fully taxable at your marginal tax rate in the year you make a withdrawal.
This is summarized in the following diagram (don't judge my lack of artistic ability).
How much can I contribute to an RRSP?
Maximum RRSP contribution= contribution limit for the current year + Unused contributions carried forward from previous years.
Your contribution limit for the current year is 18% of your income, up to a maximum amount. In 2020, the maximum contribution is $27,230.
If you made $100,000 per year and had $25,000 of unused RRSP contributions from previous years, the most you could contribute to an RRSP would be $18,000 ($100,000 X 18%) + $25,000= $43,000.
What investments can I hold inside my RRSP?
You can hold all manner of investments inside your RRSP including.
Cash
stocks
bonds
options
GICs
Mutual fund
Index funds & ETFs
Your RRSP is a particularly good place to hold U.S stocks and U.S listed ETFs. If you invest in U.S stocks in any account other than an RRSP, you will need to pay a 15% withholding tax on any dividends you receive. This tax may or may not be recoverable depending on the circumstances.
However, dividends from U.S stocks held inside an RRSP are exempt from U.S withholding tax. This is the result of a tax treaty between Canada and the U.S. This makes your RRSP the most tax-efficient account to invest in U.S stocks.
When can I withdraw from an RRSP?
There is a commonly held belief that you cannot withdraw from your RRSP before you reach retirement age without paying a penalty. This is not true.
You can withdraw from your RRSP at any time. The financial institution where you hold your RRSP account is required to apply withholding tax from the amount you withdraw. The amount of withholding tax depends on how much you withdraw up to a maximum of 30% (31% in Quebec).
Then you file your taxes you are refunded or must pay, the difference between the withholding tax and your actual tax rate.
For example, if a 30% withholding tax was applied to your RRSP withdrawal and your actual tax rate for the year was 40% you would need to pay tax on the additional 10% of your withdrawal. Remember RRSP withdrawals are considered taxable income.
If your actual tax rate was only 20%, you would receive a tax refund equal to 10% of the amount of your RRSP withdrawal.
It's important to know that when you withdraw from your RRSP you will not get that contribution room back. Withdrawing from an RRSP before retirement means you are sacrificing years of tax-free investment growth. Doing so will make funding your retirement more difficult.
There are two situations where you can withdraw from an RRSP without paying any taxes.
1. Homebuyers Plan (HBP)
2.Lifelong Learning Plan (LLP)
Homebuyers Plan
The Homebuyers plan is designed to help first-time homebuyers come up with a down payment on a home. If you meet the eligibility requirements you can withdraw up to $35,000 from your RRSP to use as a downpayment on a home.
There is a catch though. You have to pay the money back into your RRSP within 15 years of making the withdrawal. So, in essence, you are borrowing from your retirement to buy a house but you have to pay yourself back.
Lifelong Learning Plan
Under the Lifelong Learning Plan, you can withdraw up to $10,000 per year up to a total of $20,000 over a 4-year period to pay for education for yourself or your spouse. You cannot use this for your children's education, that is what a Registered Education Savings Plan (RESP) is for.
You need to start paying back your withdrawal from the Lifelong Learning Plan into your RRSP within 5 years of your initial withdrawal. From there, you have 10 years to pay back the full amount into your RRSP.
If you withdrew $10,000 in the first year of a 4-year university degree. You would need to start paying the $10,000 back into your RRSP a year after graduating. Then you could contribute an additional $1,000 per year to your RRSP to pay back the LLP.
It's important to note that when paying back the HBP & LLP, you must specify on your taxes how much of this year's RRSP contributions are going towards paying back either of these programs and how much are "regular" RRSP contributions.
Be aware of how your investments are structured
If you plan on investing in ETFs that hold U.S & international stocks inside your RRSP be aware of how that fund is structured. It will impact the level of withholding tax you need to pay.
There are two levels of withholding taxes that could potentially apply to dividends received from foreign companies.
Level 1 (L1) withholding tax: These are withholding taxes levied by a foreign government when a Canadian investor receives dividends from a company in that country.
Level 2 (L2) withholding tax: This is an additional withholding tax (typically 15%) applied by the U.S government. Level 2 withholding tax applies to dividends paid to a Canadian investor by a Canadian-listed ETF that owns a US-listed ETF. You still have to pay level 1 withholding tax in addition to this 15% withholding tax to the U.S government.
Obviously, the name of the game should be to avoid level 2 withholding tax.
This infographic summarizes how different ETFs attract level 1 or level 2 withholding tax depending on what type of account you hold them in.
For a full breakdown of the withholding taxes that Canadian investors may have to pay, read this article.
How to open an RRSP in Questrade
As I've written in the past, I believe Questrade is the best platform for Canadian DIY investors and is where I manage my own investments, including my RRSP.
To open an RRSP in Questrade click "Open an account" on the top right of the home screen.
Then select Retirement Savings Plan (RSP).
From there you will be asked a series of questions to open your account. If you have any difficulty or are confused, you can always use the "Chat" feature at the bottom of the screen to chat with an agent who can help you.
There you go. Everything you need to know about RRSPs. From what they are, how they work and how to open one up and start investing.
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.