RRSPs are a Canadian government program to encourage people to save for their retirement. When you contribute to your RRSP, you can deduct the amount from your taxable income – reducing the tax that you must pay. This is known as an RRSP deduction.
Every working Canadian should be taking advantage of RRSPs. Read on to learn more about how you can build your retirement nest egg while receiving a tax break.
What is an RRSP?
An RRSP is a savings account that allows you to sock away money for your retirement. Not only is your contribution tax deductible, but your investments grow tax-free. You only pay tax when you withdraw from your RRSP, either upon retirement or if you face a cash crunch.
How does a RRSP work with income tax?
When you file your income tax return, you can deduct RRSP contributions to reduce your taxable income. For example, if you earned $50,000 and put $5,000 into your RRSP, you would only pay tax on $45,000. Assuming that your employer has been deducting tax from your paycheque on a regular basis, this should result in your getting a tax refund at the end of the year.
How does a RRSP deduction limit work?
The government provides a tax break when you contribute to your RRSP, but there are limits to their generosity. You can contribute up to 18 percent of your previous year’s income. The annual contribution limit in 2021 is $27,830 – regardless of how high your income is. If you have not contributed the maximum in past years, you will be eligible to carry forward these unused RRSP contributions to the current year. This amount will accumulate and the total is known as “contribution room.”
RRSP deduction rules
- Who qualifies: Anyone who has earned income during the year and files an income tax return can make an RRSP contribution and claim the tax credit.
- Limits: You can contribute 18 percent of last year’s earned income. You have to deduct any company contributions to arrive at your annual contribution limit.
- When: You can contribute anytime. If you contribute within 60 days of the end of the year, you can claim this tax deduction on your income tax return. The contribution deadline for 2021 is March 1, 2022.
- Investments: You can put your RRSP contribution into a wide range of investments, including GICs, individual stocks and mutual funds. There are certain investments you can’t hold in your RRSP, including real estate and personal valuables like art and antiques.
How to claim an RRSP deduction on income tax
At the end of the year, your investment organization will add up all of your RRSP contributions. They will send you a receipt for the total. When completing your tax return, you simply include this amount on the line “RRSP deduction”. This will reduce your taxable income accordingly, so you will owe less tax (or receive a refund).
Can I claim RRSP contributions from previous years?
Absolutely. There are times when it is better to make a contribution but not claim the tax credit in the same year. You can keep the tax credit for the following year.
RRSP Deduction Example:
Robert took a six-month leave from his job to care for his newborn son James. His income for the year consisted of parental leave EI benefits plus his salary from his job. His total income for the year was $40,000. His 2021 limit is 18 percent of his previous year’s income of $70,000 – so $12,600.
He plans to return to work next year, earning $70,000. He has contributed $1,000 to his RRSP. Should he claim these contributions and deductions this year or wait until next year?’
Based on his income of $40,000, he would be taxed at 15 percent. This means that a $1,000 RRSP contribution would generate $150 in tax savings. However, if he waits until next year when his income his higher, the same $1,000 would generate $205 in savings based on a tax bracket of 20.5 percent. Therefore, it looks like it would be better to claim the deduction next year.
How much to put in a RRSP for a tax refund?
It depends. If you are employed and your company has been deducting income tax throughout the year, you can generate a tax refund with a very small RRSP contribution. If you are self-employed and haven’t remitted any income tax during the year, you may need to make a large RRSP contribution in order to get a refund.
Most financial advisers encourage clients to focus on building their RRSP contributions and deductions – not on the size of the tax refund. Sure, it gives you a hit of dopamine when you receive that refund. But the long-term goal should be building up a nest egg so that you can enjoy your retirement without worrying about money.
In summary: RRSP deductions
Registered Retirement Savings Plans are a great way to save for your retirement. In addition, you will get a tax deduction and usually receive a tax refund when you make a contribution. However, it’s most important to focus on saving the maximum amount for retirement rather than the immediate tax break. This long-term strategy will pay off eventually.
