Hello again this is Molson Montgomery and today I'm going to speak about Canadian RRSPs.
I've been fielding a lot of questions lately that boil down to “Is an individual RRSP a good idea?” My answer: there are many other options other than an individual RRSP that you should be contributing to first, period. This advice stems from the fact that there are several limitations to RRSPs that many people are not aware of.
What is an RRSP?
RRSP stands for registered retirement savings plan. It is a way for individuals in Canada to contribute to their retirement in a tax advantageous way. Every dollar you invest in your RRSP is deducted from your income, which lowers the amount of taxes you owe to the government. This sounds like a great deal, but like all great deals, it comes with a catch.
RRSP Limitations and Penalties
When your money is invested inside an RRSP, it’s not fully yours. You can’t withdraw money from your RRSP without paying a penalty until you reach the age of 55. Once you reach the age of 71, you’re forced to withdraw from your RRSP and pay taxes on it, even if you don’t need the money. You also have to be careful not to contribute too much money to your RRSP, or you’ll be paying yet another penalty. Why? Because the government needs the money they so graciously lent you, the individual.
Early Withdrawl Penalties
If you are under the age of 55 and you need the money from your RRSP, you will be on the hook for a penalty as well as the extra taxes owed for money being added to your income. In 2022, the penalty for withdrawing from your RRSP before age 55 grows with the amount you take out:
Amount Withdrawn | Penalty |
$5,000 or less | 10% |
$5,001 - $15,000 | 15% |
$15,001 + | 20% |
This is on top of the income tax you would incur.
There are only two reasons why you can draw your money out of your RRSP before the age of 55 without penalty: if you are funding your education, or if you are buying your first house. In each case, you have to pay the amount back over the next several years (or the penalties start).
Forced Withdrawl
One of the birthday presents you get from the Canadian government when you turn 71 is a RRIF. RRIF stands for Registered Retirement Income Fund, and your RRSP must be converted to a RRIF by your 71st birthday. A RRIF is similar to an RRSP, with the primary difference being that money must be withdrawn every year, if it’s needed or not. The amount varies with your age, starting from 5% up to 20% per year.
For Example, a person turning 71 in 2022 needs to withdraw 5.28% of their total portfolio. If their account had a balance of $1,000,000, they would have to draw out $52,800 for the year. I want to make sure this is very clear: this $52,800 must be withdrawn in 2022, and you must pay taxes on it. The decision to withdraw from your account is out of your control.
This forced withdrawl carries another risk. If the amount I have to take out is above a specified threshold, government funded pensions that I've paid into may be clawed back.
Contribution Limits
In 2022, an RRSP contribution is limited to 18% of your earned income from the prior year, up to a maximum of $29,210. If you decide to contribute more, whether by accident or on purpose, you'll have a monthly penalty of 1% that is applied to the contributions that are made in excess of the limit. For example, if you contribute $1000 over the contribution limit that you are allowed, you would then have to pay $10 every single month in penalty.
Luckily there is an exception to this rule. Our RRSP allows us to carry over unused contributions from years past. This means you can invest more than the yearly maximum into your RRSP. If you didn’t max your contribution previously.
Losing Control
As bad as the penalties are, the major problem with RRSPs and RRIFs for me is that you don’t have a choice about how you manage your money. If your investments lose money over the year, that means that you must draw your money out of the registered account at a loss. We also have no control over what the federal government decides to do with increasing or decreasing taxes and what the tax rate limits are. So at the end of the day, I have no control over the tax situation and I have no control over whether I'm allowed to draw the money out or not. Those are two major issues when in retirement.
It’s Not All Bad
When do I think an RRSP is a good idea? Well, I think that an RRSP inside of a group plan with a matching program is hands down the best investment in Canada. Free money from the matching program is a huge deal - no financial advisor is going to outperform free money. The group RRSP is beneficial because usually, the MER (management expense ratio) is lower than if you had an individual RRSP at a bank. The third thing about a group RRSP that I like is that the contributions are out of sight and out of mind. The investment is an amount of money that comes off your paycheque that doesn’t hurt your monthly budget.
The Bottom Line
So what do I recommend? Well, I recommend matching whatever program you have at work with the max amount you can. That doesn't mean that you have to max out your contribution limit, it means you can max out your personal limits on how much you can contribute to get that match. The second thing I would suggest is starting a tax-free savings account and begin contributing to that aggressively, using a dollar cost average strategy. For most people, this is all they need, unless there are dependents. Then they also need an emergency fund somewhere in a savings account.
If you have any questions or concerns, please connect with us and we will get you in touch with an expert in your area.
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