A Registered Retirement Savings Plan or RRSP is a type of Canadian account for holding savings and investment assets. Introduced in 1957, the RRSP's purpose is to promote savings for retirement by employees. It must comply with a variety of restrictions stipulated in the Canadian Income Tax Act. Rules determine the maximum contributions, the timing of contributions, the claiming of the contribution tax credit, the assets allowed, and the eventual conversion to an RRIF (Registered Retirement Income Fund) in retirement. Approved assets include savings accounts, guaranteed investment certificates (GICs), bonds, mortgage loans, mutual funds, income trusts, corporate shares (stocks), foreign currency and labour-sponsored funds.
RRSPs have five effects:
- Taxes on earned (employment) income (to the extent contributed to the plan) are deferred until the eventual withdrawals from the plan. There is no benefit from the deferral because it is an accrued liability that grows at the same rate as the investments themselves. The tax deferred is commonly called the contribution tax credit.
- Income earned inside the plan on the after-tax savings (excluding the contribution tax credit) is not taxed either while within the plan or on withdrawal. Asset classes that attract the highest taxes (%income * %tax rate) are best kept within the plan to maximize the deferral benefit.
- One's marginal tax rate when withdrawing cash may be higher (or lower) than the rate at which one claimed the original contribution credit. This creates a penalty (or benefit) equal to (change in tax rate %) divided by (1 minus tax rate on contribution).
- Canada has a variety of programs available to retired people whose benefits decrease as one's income increases. By deferring the income until retirement, the additional income created at that time may reduce those benefits.
- Claiming the contribution tax credit may be deferred until a later year (when the expected marginal tax rate is higher), but there is an opportunity cost penalty for the delay; the potential income the tax credit could have earned during the delay.
Read more about Registered Retirement Savings Plan: Taxation, Contributing, Withdrawals, Account Structure, RRSP Rollover
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