This morning we have a little something for our neighbors to the north. This is a guest post from Frugal Trader, who writes about personal finance from a Canadian perspective at Million Dollar Journey.

J.D contacted me to contribute to his retirement account series with an explanation of Canadian RRSPs. An RRSP is the closest thing Canada has to a 401k or Roth/Traditional IRA.

What is an RRSP?
RRSP stands for Registered Retirement Savings Plan. An RRSP account acts just like any investment account, but with differences in the way that the account is taxed and the contribution limits.

How does it work?
The tax advantages of the RRSP are what gives it mass appeal. Every deposit into an RRSP account reduces your taxable income for that year. In other words, if you are in the 40% tax bracket and contributed $5000 for the year, you would receive approximately $2000 back in the form of a tax refund. On top of the tax refund, all investments and distributions can compound tax-free within the RRSP account.

Sounds like a great deal right? The catch is that when you withdraw from the RRSP, the money is taxed as income at your marginal rate. The goal of the RRSP is to start young, let the investments compound tax-free over a number of years, and start withdrawing in later years when you have lower income. This way you get the tax refunds while you are in a higher tax bracket (working years), but pay taxes on the withdrawals while in a lower tax bracket (during retirement).

Who should contribute to an RRSP?
I think that every working person should have an RRSP providing that they are not a permanent low-income earner. Low income earners will have better tax opportunities and government benefits investing outside of an RRSP.

If you are young and just starting out in a low tax bracket, you have two options. Providing that you have contribution room, you can begin contributing but carry forward the tax deductions to be used when you are in a higher tax bracket. Or, you can start a taxable non-registered account and transfer the investments to your RRSP at a later date.

Where can I open an account?
If you are a Canadian resident, most Canadian Discount Brokerages offer self directed RRSP accounts. If you aren’t comfortable picking your own investments, you may want to visit a financial advisor or a local bank to help you out. Most of the big banks offer no-fee, no-minimum RRSP accounts providing that you purchase the bank offered mutual funds. This is actually a great way to start off an RRSP account as you can deposit small amounts on a regular basis.

When the RRSP account grows large enough, you may want to consider moving to a self-directed account to reduce your management fees. As with any government tax breaks, there are well-defined rules that must be followed:

  • The contribution limit is 18% of last year’s income up to a maximum of $19,000 for tax year 2007.
  • You can find your contribution limit by looking at last year’s (2006) notice of assessment or through  CRA directly.
  • The contribution deadline for tax year 2007 is 29 Feb 2008.
  • You can carry forward any unused contribution room.
  • You can over-contribute up to $2,000. (In other words, you can contribute up to $2,000 more than the 18% ceiling.) However, it makes little sense to do so as there are no tax benefits. There is a penalty tax if you exceed the $2,000 over-contribution limit.
  • You are forced to collapse your RRSP the year that you turn 71. Instead of withdrawing everything in a lump sum (big taxes), you have the option of converting the RRSP into an RRIF or annuity which can help reduce taxation.

Other Notes:
The RRSP also has other perks like the RRSP Home Buyers Plan (HBP), and the  Lifelong Learning Plan (LLP). These plans are out of the scope of this article, but both programs allow the tax free withdrawal of RRSP funds under specific circumstances and providing certain conditions are met.

I hope that you enjoyed and learned something from my RRSP article. If you have any questions, I’ll be hanging around the comments here. Alternatively, feel free to  contact me via email, or by leaving a comment on Million Dollar Journey. Please note that I’m not a financial advisor and the advice above is based on my experience and opinion only.