This post was updated on April 10, 2013
In January and February, many of us try to scrape together our registered retirement savings plan (RRSP) contributions for the previous taxation year in order to lower our taxes due in April. An RRSP is a special account used to save for retirement and it has distinctive tax advantages. Unlike other registered accounts (such as a registered education savings plan or a tax-free savings account), RRSP contributions are tax deductible, meaning they are made with pre-tax dollars.
Another advantage of RRSPs is that you don’t pay any tax on your investment earnings while the funds remain in the plan. This is known as tax-free compounding, and it means that your savings can grow faster than they would if they were held in a taxable account.
You are also able to defer tax on your contributions and your earnings until you retire. You are only taxed when your RRSP savings are withdrawn, when you may be in a lower tax bracket. You must collapse your RRSP before the end of the year you turn 71 years of age, but you can convert your RRSP into a registered retirement income fund (RRIF) and your investments will continue to be sheltered from tax. However, you have to withdraw a minimum amount from your RRIF every year.
The deadline for making your 2011 RRSP contribution was February 29, 2012 and many of us probably waited until the last minute. [Update: The deadline for 2012 RRSP contributions was March 1, 2013.] But a better strategy is to make your RRSP contribution for 2012 earlier in the year if you have the funds available. This gives your investment an additional 12 months to grow tax free.
If a lump sum at the beginning of the year is not practical, try to “pay yourself first” by making regular monthly contributions to your RRSP directly from your paycheque. Ask your bank or broker to set up the transfer automatically, so you are not tempted to spend this money. Somehow, you will learn to live without it by cutting back on other discretionary spending, such as dining out, entertainment or shopping.
You must have “earned income” such as employment, business or rental income to contribute to an RRSP. Your RRSP deduction limit is 18% of the previous year’s earned income, subject to a dollar maximum. The dollar maximum was $22,970 for 2012. [Update: The maximum for 2013 is $23,820.] If you’re not sure what your 2012 RRSP deduction limit is, check the notice of assessment you received from Canada Revenue Agency (CRA) for your 2011 tax return. You can also find it online if you have signed up for CRA’s MyAccount.
In the next post, we’ll examine how to save using another registered account, the tax-free savings account.