The first 60 days of every year is known as RRSP season. March 1, 2011 is the RRSP deadline when Canadians can make contributions to an RRSP and have it eligible for a tax deduction for the previous year (2010). Before you make a RRSP contribution, here are some basics you need to know.
What is an RRSP?
The RRSP is a well-known account that has been around since 1957. RRSP is short for Registered Retirement Savings Plan. The plan is designed to help individuals save for retirement by giving them two tax benefits. The first is a tax deduction and the second is tax deferred growth. With these two benefits, RRSPs remain one of the best ways to save for retirement.
How much can you put into a RRSP?
There are two ways to figure out how much you can contribute to a RRSP. Let’s start with the harder way. Basically, there is a formula to determining your RRSP contribution limit, which goes like this:
18% of your previous year’s earned income less your previous year’s pension adjustment to an annual maximum.
The easier way to know how much you can contribute to your RRSPs is to look at your Notice of Assessment (NOA). This is the form you get back from the government once you have filed your return. It will include any unused RRSP contribution room from the past. Here’s an article I wrote for more details on determining your RRSP limit.
Are RRSPs a good thing?
There are some situations when you should not buy an RRSP but for the most part, RRSPs do make sense. The ideal situation for RRSPs is when you can put the money into the RRSP when you are in a higher tax bracket than when you take the money out of the RRSP. I call this the one formula approach to RRSPs.
What’s the best way to buy RRSPs?
The best way to buy RRSPs is to make it automatic. Studies have shown that those that contribute to RRSPs regularly whether it is off their paycheques through employer sponsored Group RRSPs or through preauthorized debits from the bank account tend to save more and have more money in RRSPs. It’s the habit of saving that makes all the difference.
What should you invest in?
This is probably the hardest decision for most people. There is no shortage of choices. You can invest in savings accounts, money markets, GICs, mutual funds, stocks, bonds, Exchange Traded Funds (ETFs) and so much more.
How you invest your RRSPs will depend on what stage of investing you are at. When you are first starting out with your first RRSP contribution, you will likely keep it simple. The more money you have in your RRSPs, the more sophisticated you can get. Not matter how much you have you might want to know my 5 timeless tips for investing your RRSPs
When should I take money out of the RRSPs?
RRSP stands for Registered Retirement Savings Plan. Therefore, the ideal situation is to make an RRSP withdrawal when you retire. When you take the money out of the RRSP, you have to pay tax at your current marginal tax rate. Taking money out of RRSPs while you are still working full time is not ideal because you are typically in a high tax bracket and you lose that contribution room forever.
How does withholding tax work?
Essentially, the government says that any withdrawals less than $5,000 will be subject to a withholding tax rate of 10 per cent. For example, if you take out $4,000 from your RRSP, you will only get $3,600 because $400 (or 10 per cent) will be sent to the Canada Revenue Agency for taxes withheld at source. If you take out a lump sum between $5,000 and $15,000, you will be subject to 20-per-cent withholding and any withdrawals greater than $15,000 will be subject to 30-per-cent withholding.
The most important point to stress is that the withholding tax rate is not your marginal tax rate. Often people try to minimize withholding tax, thinking that that will be their total tax bill but they get surprised at the end of the year with additional taxes owing.
2011 RRSP Kit
I have just released my special report, 2011 Annual RRSP Kit available to my monthly newsletter subscribers. If you want a copy, just subscribe to my monthly Bright Ideas Newsletter.