RRSP misconceptions and myths abound, but in this post, we cover the top 10 you need to know
Common RRSP Misconceptions
1. RRSPs are tax exempt
This is an RRSP misconception that is quite common and can be partly blamed on how the financial institutions market RRSP. Canadians are encouraged to make contributions before the deadline to qualify for the tax deduction and get some refund.
However, while the contribution can be deducted from your taxable income, and effectively tax exempt for that year, you’ll still have to pay taxes some time in the future when you start withdrawing.
RRSPs are tax-deferred plans, that lets your contributions, and the returns made on them, grow tax-free until you’re ready to start making withdrawals.
So, the tax shelter is temporary, but it could result in lower taxes paid if used correctly.
2. RRSP withdrawals can only be made when you retire
As popular as this RRSP myth is, perhaps because the second R in RRSP is Retirement, it is incorrect.
Yes, RRSPs are meant for retirement savings by design, but CRA permits withdrawals, without a tax implication, for two other purposes.
- Home Buyer’s Plan: allows a maximum of $35,000 to be withdrawn by a first-time home-buyer. The amount withdrawn must be fully repaid within 15 years, but repayments can be delayed for 2 years. Learn more about how to withdraw under the home buyers’ plan.
- Lifelong Learning Plan: Up to $20,000 to be repaid within 10 years. Read more here: Guide to Lifelong Learning Plan (LLP)
Any RRSP withdrawals for other purposes will attract a withholding tax of up to 30% depending on the amount withdrawn.
Withdrawals of $5,000 or below attracts a rate of 10%; between $5,001 and $15,000, the withholding tax rate is 20%; and it rises to 30% for withdrawals above $15,000.
The withholding tax is different for Quebec residents: it is 15% for all withdrawal amounts plus the federal withholding tax of 5%, 10% and 15% for the three withdrawal brackets indicated above.
3. TFSA is better than RRSP
TFSA withdrawals are completely tax-free but you don’t get a tax deduction for your contributions. On the other hand, taxes are payable on RRSP withdrawals.
But this doesn’t mean TFSAs are better. Remember, RRSP contributions were never taxed in the first place, but TFSA contributions are post-tax.
Some factors to consider in choosing between the two includes:
- Your current tax rate and what you expect it to be in the future. This largely depends on your income level. RRSPs are best if you expect to be in a lower tax bracket than you were when you make the contributions.
- Your investment goal: If you are saving for a short or medium-term goal like a new car, a TFSA is better. For a first-time homeowner, you may choose an RRSP and take advantage of the Home Buyer’s Plan.
Obviously, the best one will vary from one person to another and each person should choose the one that maximizes their investments on the long run.
4. RRSPs are better than TFSA
As mentioned above, this depends on a lot of factors peculiar to each individual. Each taxpayer has different circumstances, so the best savings plan between the two can not be generalized.
5. Refunds are tax-savings
Not exactly and this can be tricky.
First, RRSP contributions are made pre-tax. That is, before taxes are calculated on your income, so the tax refund is really CRA giving you back what was always yours.
Your true tax savings depends on your current tax rate and what it will be when you withdraw in the future.
For example, if you contributed $10,000 when you have a marginal tax rate of $30% but make withdrawals when you’re in a lower tax rate of 15%, your tax savings is the tax refund of $3,000 minus the tax paid on withdrawal of $1,500.
This is a simplification that ignores time value of money and doesn’t consider what you do with the tax refund received.
On the other hand, if you withdraw at a higher rate than 30%, you’ll be paying more than the refund you got.
Of course, it is almost impossible to know what the tax savings will be upfront. There are just too many unknowns.
So, make a reasonable guess, decide on the right plan for you (TFSA or RRSP) and start investing now. You can always make changes as things become clearer.
Related Post: Keep More Of Your Income And Reduce Your Tax Refund
6. You must sell off all your investments when you get to 71
This is a misconception, there are other options for dealing with your RRSP at 71.
The last day you can contribute to your RRSP is December 31 of the year you turn 71. After this time, you will need wind down your RRSP by choosing any of these options
- Withdraw the funds: this may mean selling off your stocks, bonds or liquidating your GICs
- Transfer to an RRIF: with this option, you can still keep all your investments
- Use them to purchase an annuity
After age 71, there’s a minimum amount you must withdraw annually – calculated as the market value of your RRIF holdings multiplied by a factor that varies annually.
7. You can only open an RRSP with a Bank
On the contrary, you can open an RRSP with many other financial institutions including insurance companies, credit unions, online brokerages, and robo-advisors.
Also, you can easily setup regular pre-authorised transfers to move funds from your bank to your RRSP for investment.
Many people like the flexibility of having all their accounts with a single financial institution. Yes, having all your accounts with a single bank may be more flexible but there are instances where you may need to open your RRSP account with another financial institution.
8. You must make the maximum allowable contribution every year, otherwise you’ll lose it
No, you can carry forward any unused contribution room to future years. RRSP contributions can be made till December 31 of the year you turn 71.
For example, if your allowable contribution room for 2019 was $20,000 but you only contributed $12,500. The $7,500 difference will be added to your 2020 annual RRSP limit (18% of 2019 earned income or $27,230, whichever is lower)
9. You must invest the money you contribute before the annual deadline.
If you get caught up in the rush before the annual deadline, it is okay to leave your contribution in cash. Once the funds get to your RRSP account, it’ll be recorded as a contribution for the year even without investing it.
But make sure you invest the funds as soon as you can to maximize your long term returns.
10. Contribute as much as possible
Firstly, you should not be contributing to your RRSP when you’re in a lower tax bracket. Wait till you’re in a higher tax bracket than where you think you’ll be at retirement. Those refunds may look enticing today, but tax-wise you may be better off using a TFSA instead.
Unlike TFSA withdrawals, your RRSP withdrawals are added back to your taxable income for the year then taxed. This means your income tested benefits like Old Age Security (OAS) could be affected by the government claw-back.
Also, without proper succession planning and depending on who your beneficiaries are at death, leaving behind a high RRSP balance may lead to a large chunk of your assets going to CRA or probate fees.