You probably won’t want to continue working after you are retired and will need to find a way to cover your living expenses during retirement.
If you worked throughout your life, you will be able to collect Canada Pension Plan (CPP) benefits (assuming you paid into CPP), which is only intended to cover 25% of the average industrial wage (which is about $45,000). If you have lived in Canada for more than 10 years after age 18, you may be entitled to receive Old Age Security (OAS) as well.
These programs may not cover all of your living expenses and you will probably need to find other sources of income. If you have a pension through your employer, this may cover more of your retirement income, but the rest of your retirement income must come from you! Hence the need for the RRSP.
What is An RRSP?
A Registered Retirement Savings Plan or RRSP is a special kind of savings or investment account that is set up and registered with the Canada Revenue Agency. The RRSP allows you to defer income tax on the money deposited in the account until it is withdrawn, usually in retirement.
How RRSP’s Work
Contributions made to an RRSP are tax deductible from your current income (subject to annual RRSP limits) while payments or withdrawals from the RRSP are taxed. Any investment income that accumulates inside of an RRSP is not subject to income tax. Similarly, and investment losses are also not subject to tax and you cannot claim a deduction.
Who Can Contribute To An RRSP?
Anyone with earned income in the prior tax year can contribute to an RRSP. And while there is no minimum age, RRSP’s must be deregistered by December 31st of the year a taxpayer turns 71.
The Benefit of an RRSP
If you expect to be in a lower income tax bracket when you retire, an RRSP make good economic sense. For example, if you current marginal tax rate is 30% and when you retire you expect to be in a 20% tax bracket, you have realized a net savings.
Assume you currently earn $50,000 and are in the 30% marginal tax bracket. If you contribute $4,000 to an RRSP, you will receive a tax refund of $1,200. When you draw out the $4,000 in retirement when you are in a 20% tax bracket, the tax bill will only be $800. A tax savings of $400!
If you expect to be in the same or higher tax bracket in retirement, then an RRSP may not make much sense and using a TFSA may be a better option.
RRSP’s are a offer more flexibility and control than other forms of retirement savings, such as registered pension plans. With registered pension plans, once the plan is established and registered neither the employer or the employee have are committed to making regular contributions to the RPP. With an RRSP, there is no requirement that a contribution actually be made to the plan (only that the contribution limits not be exceeded).
RRSP’s also offer a choice of investment options. On the other hand, the defined benefit pension plan guarantees your retirement income and the investor does not need to be involved in the investment decision making.