A user's guide to RRSPs

Once again, the clock is ticking down to this year's deadline for RRSP contributions. March 1 is the date to keep in mind if you are looking to get a tax break applied to your 2013 income.

For many people, just getting around to setting aside some part of their income can be a challenge.

Then there's the issue of where to put your money. Many people simply plop it into an interest-earning savings account while others prefer to play the stock market and cash in their profits immediately rather than diverting them to a retirement account.

Twenty-four per cent of eligible tax filers contributed to an RRSP in 2011. Although the average contribution that year was $5,778, the median contribution was only $2,830, meaning half the people contributed more than that and half less.

One reason for the low participation and contribution rates in RRSP plans could be growing competition for Canadians' disposable income.

Household debt is at an all-time high, so paying down debt is a top priority for many.

Statistics Canada reported in December 2013 that the ratio of credit market household debt to disposable income hit 163.7 per cent in the third quarter of 2013, up from 163.1 per cent in the previous quarter.

At the same time, tax-free savings accounts are entering their fifth year of existence and are grabbing an ever growing share of the investing pie.

So, once again, Canada's financial industry will be doing its best this year to grab your attention with its annual ad barrage about the various financial products its hawkers would love to persuade you to stuff into your RRSPs.

At this time of year, financial planning firms, mutual fund companies, discount brokers, banks, insurance companies and credit unions are all in full blitz mode trying to persuade you that they are the ones that can best nurture your precious retirement money (and reap some fees and commissions for themselves in the process).

How it all began

The first RRSP — then called a registered retirement annuity — was created by the federal government in 1957. Back then, Canadians could contribute up to 10 per cent of their income to a maximum of $2,500.

So, what are you going to do this year?

First, let's take a look at the nuts and bolts of what's become an annual rite of financial passage for millions of Canadians.

Why should I RRSP?

Old Age Security payments and Canada Pension Plan benefits will together provide only a bare bones retirement income. In the absence of a company pension or other savings, the gap between a basic and a more comfortable retirement can often be made up with an RRSP.

According to Statistics Canada's most recent figures, membership in registered pension plans (RPPs) amounted to 6,065,750 in 2010, an increase of 42,000, or 0.7 per cent, from 2009. Membership increased in public sector plans but declined in private sector plans.

Membership in public sector pension plans rose 1.8 per cent to 3,140,970 while the number of members in private sector plans declined 0.5 per cent to 2,924,790.

Since funds in an RRSP grow in a tax-sheltered environment, they can balloon to an impressive figure without the nuisance of having to pay tax every year on all that growth.

For instance, depositing $5,000 a year each year for 25 years into an RRSP will eventually yield an account worth almost $280,000, assuming five per cent annual compounded growth. Make it eight per cent, and your nest egg grows to almost $420,000.

Of course, the effects of 25 years of inflation will mean that the nest egg's buying power in 2038 won't be as dramatic as it was in 2014. And when it comes to time to convert that RRSP into a RRIF or annuity, those payouts will be taxable.

That's why RRSPs are really appropriate for people who want to defer income (and, therefore, taxes) from a period of higher income (during one's working life) to a period of expected lower income (in retirement).

And while there seems to be enormous pressure for everyone to contribute to RRSPs, keep in mind there may well be better ways to use your money. For younger workers just starting out or for low-income seniors, it may make more sense to have contributed to a tax-free savings account. For those with a lot of high-interest credit-card debt, it may be better to pay that off first. For young families with mortgages, it may just be too difficult to come up with RRSP money.

Don't fret if you can't afford to make a contribution now. After all, unused RRSP contribution room can be carried forward indefinitely.

Types of plans

Individual RRSP — As the name implies, this account is registered in the name of the contributor.

Self-directed RRSP — Do-it-yourself investors set up self-directed plans that can hold a wide range of investments together in one plan. Annual trustee fees of $100 or more are often waived for those with at least $25,000 in plan assets, but transaction costs are the holder's responsibility.

Group RRSP — These are set up at work. The employee and/or the employer contribute money to individual RRSP accounts. Contributions are deducted from paycheques so the tax savings are immediate. Investment choices may be limited.

Spousal of Common-Law Partner RRSP — With these RRSPs, the higher-income spouse makes a contribution to the other spouse or partner's RRSP. The contributor gets the tax deduction, but the money is now owned by the other spouse or partner. So when the money is withdrawn from the spousal RRSP, it's taxed at the lower-income spouse's rate. This is a form of income-splitting that is especially useful when one spouse or common-law partner has a significantly higher retirement income than the other.

How much can I contribute?

For the 2012 tax year, people can contribute up to 18 per cent of their earned income in 2011, up to a maximum of $22,970. That means it's necessary to have earned income of at least $127,611 to contribute the maximum.

But the contribution calculation isn't that simple. From that figure, you must subtract your pension adjustment amount (PA). If you're a member of a pension plan at work, you'll have a pension adjustment. This takes into account the money you and/or your company contributed to an employer-sponsored pension plan. Your T4 slip records the pension adjustment figure.

To this figure, you must then add the total carry-forward of unused RRSP contribution room since 1991. For some taxpayers who haven't been stuffing their RRSPs to the limit, this can amount to more than $100,000.

There's an easy way to find out how you can contribute to an RRSP each year without doing all the calculations. Just check the Notice of Assessment you received from the Canada Revenue Agency last year, or phone the tax department's T.I.P.S. line at 1-800-267-6999. You will be asked to provide your social insurance number, your month and year of birth, and the total income you reported on line 150 of your 2011 return.

What can I invest in?

With a self-directed RRSP, you can put money into a wide variety of investments — all inside a single plan.

These can include guaranteed investment certificates (GICs), mutual funds, government and corporate bonds, exchange-traded funds (which can track market benchmarks like the S&P/TSX 60 composite index), mortgage-backed securities, gold and silver bullion and stocks. You can even invest in your own mortgage.

Or you can just stick your cash in an interest-bearing account while you figure out what to do. The old foreign-content rule, which used to limit the amount of money you could put into foreign investments, no longer exists.

According to an RBC phone survey released in December 2012, mutual funds are the most popular investment choice for those with RRSPs, accounting for 46 per cent of RRSP investments, followed by GICs (24 per cent) and savings accounts (22 per cent).

Given that the S&P/TSX composite index was one of the worst-performing stock markets in the world this past year, and most financial analysts are predicting a similarly lacklustre performance and more market volatility in 2013, a lot of financial experts are advising their clients to diversify their RRSP holdings. Many have been promoting a balanced approach, looking at a combination of equities, fixed-income investments and cash.

According to Investor Economics, Canadians had about $877 billion in RRSP assets as of June 2013.

What's the deadline?

You really can make a contribution at any time.

The only RRSP deadline you face is if you want the tax break applied to your 2013 income. In that case, the deadline is March 1, 2014.

But you can carry forward unused RRSP contribution room to next year, or the year after that, and so on.

What are the age limits?

There's no minimum age to set up an RRSP, but it's better to contribute early and often to maximize growth. You can continue to contribute to an RRSP until the end of the year in which you turn 71, provided you still have earned income (or the end of the year in which your spouse turns 71 in the case of spousal plans).

Once you hit that deadline, you have three choices: 

1. Convert your RRSP into a registered retirement income fund (the most popular option). 
2. Buy an annuity (best payout when interest rates are higher).
3. Withdraw it in cash (generally not a good idea as you'll pay tax on the whole amount and won't have a retirement income).

You can also opt for some combination of the above choices.

Are RRSPs only for retirement?

While RRSP stands for registered retirement savings plan, the federal government has brought in two provisions that allow Canadians to get access to RRSP money for reasons other than their golden years.

The Home Buyers' Plan (HBP) has been enormously popular in Canada, with almost 1.4 million people taking advantage of it as of 2004, the latest year for which government figures are available. The plan allows individuals to withdraw up to $25,000 from RRSPs to buy or build their first home (the limit was raised from $20,000 in the 2009 federal budget). Since 1992, more than $14 billion has been withdrawn. As long as the money is used to buy a qualifying home, no tax is paid on the withdrawal.

The catch is that the money must be repaid to your RRSP over the following 15 years, with a minimum payment required each year, or the minimum annual payment will be added to your income, and you will pay tax on that. And the repayment is not tax-deductible because you got the tax break the first time you put the money into the RRSP.

The Lifelong Learning Plan (LLP) allows Canadians to pull up to $20,000 from their RRSPs to head back to school. The withdrawals can be a maximum of $10,000 in any one year and can be spread over four years. Repayment is on a 10-year schedule. About 49,000 people have withdrawn $363 million since the plan began in 1999.

Financial experts also point out that by raiding your RRSP for either of these plans, you lose much of the tax-free compound growth you could have made on that money, so you might want to repay the money quicker than the prescribed schedules.

Of course, you can withdraw money from an RRSP for any reason, like taking a year off to have a child or travel. But that kind of early raid will result in having to pay tax on every penny withdrawn, and the contribution room will be lost forever. In most cases, it would make more sense to use a tax-free savings account for such short-term cash needs, as there are no tax consequences when making withdrawals from a TFSA, and you get that contribution room back in subsequent years.