How RRSPs Work: Everything Beginners Need to Know

Whether you can afford to put aside a lot of savings each paycheck or only a little here and there, every dollar you put into an RRSP will not only help you save for retirement but will also help lower your yearly taxes. If you’re still not sure what RRSPs are or how they work, keep reading for a quick look at everything you need to know to start saving. 

Don’t let the name fool you. An RRSP (short for “registered retirement savings plan”) might sound a little boring, but it’s actually an incredibly powerful tool that will help you keep more money in your pocket—now and tomorrow. 

Backed by the Canadian government, the primary goal of an RRSP is to help you save for retirement. It does this by lowering your annual taxes and letting you build compound interest tax-free. 

In other words, as a reward for putting some of your own money aside for your retirement, the government gives you significant yearly tax breaks. You save more money, get to lower your taxes, and build compound interest faster. It’s a win, win, win. 

If you’re not already contributing to an RRSP, here’s a quick look at the basics. 

How does an RRSP work? 

An RRSP is a lot like any other savings plan but with some added perks. You can open one through a bank or other financial institution, or you may even be able to join an existing plan through your employer. 

You can “set it and forget it” by setting up automatic payments or contributions from your paycheck, or you can make contributions periodically when the time is right for you. 

Unlike other savings accounts or plans, there’s a limit to how much you can contribute each year. This limit changes slightly from year to year and is also based on your income. For example, the contribution limit for the 2021 tax year is 18% of your pre-tax income, up to a contribution limit of $27,830.

Read more: RRSP Contribution Limits, Deadlines & Tips To Know For 2022

What are the benefits of an RRSP? 

The main purpose of an RRSP is to help you maximize your savings for retirement. It does this in the following way: Every dollar you contribute to an RRSP in a given tax year lowers your yearly income in the eyes of the CRA (Canada Revenue Agency) that same year. 

This is important because the higher your income the more taxes you pay. Not only that, the higher your income goes the more likely you are to hit higher tax brackets. For instance, if you make below $49,020 your annual tax rate is 15%. If you make more than that, the dollars you earn above $49,020 are taxed higher and higher at different thresholds. Each of these thresholds is called a tax bracket. 

So by contributing to an RRSP, you’re not only reducing your taxable income, but you might also lower your tax bracket as well. 

Additionally, the interest you earn on your RRSP savings is also tax-free. This allows your RRSP to grow faster through compound interest. 

Ideally, RRSP amounts aren’t withdrawn until retirement because you do have to pay tax when you withdraw RRSP amounts. However, in retirement you’ll be earning less, paying less tax, and your RRSP dollars will have been building compound interest tax-free—for decades. 

How do RRSP contributions impact your tax bill? 

Let’s say you make $55,000 per year. You’d normally be taxed 15% on the first $49,020 of earnings, and 20.5% on the remaining $5,980. Add that all up and you could end up owing as much as $8,579 in taxes (without factoring in other deductions). 

However, if you contribute at least $5,981 to an RRSP then the CRA will treat you as if you earned $49,019 and only tax you at 15%. This means you could end up lowering your tax bill by more than $1,200! 

Not only do you save potentially $1,200 on your taxes but also the $5,981 you’ve put into your RRSP is allowed to build interest tax free, year after year, until you withdraw it. 

What if I have a spouse? 

In many cases, it makes sense to open a spousal RRSP. This is an RRSP that is shared by a married or common-law couple. 

The same contribution limits apply to a spousal RRSP so this doesn’t mean you can save more or reduce more of your taxable income. However, a spousal RRSP can be helpful in instances where one partner has a higher income than the other, for instance, if one partner has left the workforce to raise kids. 

The partner with the higher income can contribute to the spousal RRSP and then both can make equal withdrawals during retirement. Smaller, equal withdrawals can also result in lower taxes on the withdrawals compared to if one partner was making larger withdrawals. 

When filing taxes, the yearly contributions to the spousal RRSP can also be claimed in different amounts for each partner. For instance, if the couple puts $10,000 into their spousal RRSP in a given year, Partner A can claim $7,000 on their taxes and Partner B can claim $3,000. This can be advantageous depending on each partner’s income and tax bracket.

What’s the difference between an RRSP and TFSA? 

There are several key differences between an RRSP and TFSA (Tax-Free Savings Account). 

While an RRSP is essentially a tax deferral (you lower the taxes you pay in the short term and pay a lower cumulative rate of taxes when you withdraw down the road) the amount you withdraw in a TFSA will never be taxed. Additionally, the interest you earn in a TFSA will never be taxed. 

The big advantage an RRSP has over a TFSA is that an RRSP lowers your taxable income each year, whereas a TFSA does not. It’s almost always more advantageous to max out your RRSP contributions each year before putting money into a TFSA. 

Here’s a quick comparison between the two: 

Common mistakes to avoid with an RRSP 

Unlike other investment options, getting the most out of an RRSP is fairly straightforward. That being said, there are some simple and surprisingly common mistakes you’ll want to avoid, as they can derail your progress and hinder your savings goals. 

Making early withdrawals 

If you withdraw funds from your RRSP prior to retirement you’ll have to pay an immediate withholding tax on the amount you withdraw. This tax can be significant: 10% on the first $5,000 withdrawn, 20% for amounts between $5,000 and %15,000, and 30% on amounts greater than $15,000. The amount you withdraw is also considered taxable income, so you’ll be hit again when you file your annual taxes. 

Not making regular contributions 

It’s always easy to find reasons why you can’t contribute to your RRSP in a given month or pay period. That’s why it’s always best to “set it and forget” with automatic payments or contributions. This can often be set up through your bank, financial institution, or employer if it’s a group plan through work. Consistently contributing a small amount every paycheck will often put you in a better position than trying to make large (but irregular) contributions. 

Starting too late 

The best time to start contributing to an RRSP is yesterday. Time is on your side when it comes to accruing the compound gains that an RRSP yields. If you start contributing to an RRSP when you’re 35, for instance, you still have 30 years of saving and gaining compound interest to take advantage of before you retire. If you start even younger, you’re in an even better position.