An RRSP is a registered retirement savings plan that helps you compound your retirement savings for a more stable financial future. RRSPs are tax-deferred when contributing, but counts as taxable income when withdrawn. A benefit of RRSP contributions is a tax deduction. However, the deduction is a bit more complicated than you think.
Some find that instead of tax savings, they have to pay an RRSP tax. Not many people know that there is actually a sweet spot for tax-free RRSP contributions. To help you get the most of your retirement savings, we take a look at everything you need to know about RRSP contributions (see also RRSP contribution deadline here and find out how to deduct your contributions from your current taxes).
The 2021 RRSP Contribution & Deduction Limit
An RRSP is a popular retirement investment option in Canada because of its tax benefits (see also ‘RRSP Loans‘). However, the government does put a limit on contributions and deductions that may change annually.
An RRSP contribution limit refers to the maximum amount that an account holder can deposit into their RRSP every year. The limit is usually based on your income and is different for every person. It is also dependent on the set annual deduction limit or unused contributions.
The contribution limit for 2021 is 18% of the earned income on your tax return from the previous year. In addition, aside from your income, the limit caps at $27,830. This is slightly up from the 2020 limit which was $27,230. You do not have to contribute the maximum amount each year, and your contribution room will carry over to next year.
It is also important to note that if you also have a company pension plan – not to be confused with CPP, as explained here – your contribution limit will be lower. Your contribution limit will be a percentage of your income minus your pension adjustment. You and your employer determine this number based on contributions made in your other retirement plans. It is important to follow these limits. Overcontributing can lead to additional penalties.
An RRSP deduction limit refers to the total amount that a taxpayer can contribute in the given year. Unlike the contribution limit, the deduction limit does not take into account your unused contributions. If you contribute to your RRSP, it provides you with tax savings for the year. This is why the Canada Revenue Agency places a cap on the contributions.
The 2021 deduction limit is 18% of your pre-taxed income from the previous year, or $27,830. The limit is whichever amount is less. For example, if you earned $50,000 in 2020, your deduction limit would be $9,000. Whereas, if you earned $170,000, your deduction limit would be $27,830 since the CRA caps it.
Like the contribution limit, the deduction limit for your personal RRSP can be less depending on your other retirement savings. Spousal RRSPs or employer pension plans can decrease your limit.
How to Figure out Your RRSP Contribution Limit
While your deduction limit is simple to calculate, the RRSP contribution limit has other factors that you may need to consider. The contribution limit is unique to the individual because it takes into consideration the unused contribution room of previous years. To do this, you will need to know the exact amount you contributed as well as the limits for each given year.
Luckily, there are much easier ways to figure out your RRSP Contribution Limit rather than calculate it yourself. Two ways that you can determine your RRSP Contribution Limit are from your Notice of Assessment or online.
The CRA sends out the Notice of Assessment each year after you file your taxes. They help to keep track of your limit and report it on the assessment. You can find the value under the section labelled “Available Contribution Limit”.
Another way to figure out your RRSP contribution limit is through your CRA online account. You can easily set up your account and access financial information. Through your CRA account, you are able to access your tax information, pay your taxes, and also see your Notice of Assessments. For those that are unable to access the internet, you can also call the CRA number.
When you Shouldn’t Contribute to an RRSP
While it may seem like a good idea to contribute to your retirement savings every year due to tax savings, there are other factors to consider. There are benefits to calculated investing strategies that can bring you long-term tax savings. To help you decide whether or not you should contribute in that given year, there are loads of free online RRSP refund calculator tools.
The refund can make it seem like a great financial decision, however, in the long run, it may not be. One consideration to make before making a contribution is to look at the marginal tax rate and provincial income tax in your area. The marginal tax rate and the provincial tax rate can help you determine your tax bracket and allow you to make a more informed decision.
Your tax refund takes into account your taxable income, which also determines your tax bracket. Those in a higher tax bracket pay a higher tax rate than lower-income earners. The strategy is to contribute enough money to help lower you into a lower tax bracket. This helps you pay lower tax rates for the given year. Just be sure not to over-contribute so you do not have to pay tax penalties.
If you are a lower-income earner in that year and are already at the lowest tax rates, it may be a good idea to pass on contributions for that year. This is because your contribution space has restrictions, so you may want to contribute in future years when your income may be higher. The contribution space carries over, which means it may benefit you more to contribute when your marginal tax rate is also higher.
Another reason to skip on making a contribution to your RRSP is if you have a high-interest debt to pay off. This should take priority, since the longer you take, the more money you will have to pay.
What Happens if you Over-Contribute to your RRSP?
While it may seem like a good idea to invest as much money as you can for your retirement, there are consequences to over-contributing. The Canada Revenue Agency limits the investment you can make to your RRSP due to the tax savings. Which means you may have to pay for going over the limit.
If you do go over your contribution on accident, the CRA gives you a free pass for over-contributing $2,000. However, once you use that cushion up, it will cost you for over-contributing. Once you pass the $2,000, they charge a 1% fee every month for your overpayment. Once you withdraw the extra funds, there is no more penalty. However, there are also consequences for early withdrawal (see our ‘Best Way to Withdraw Money From RRSP’ post).
Should I Max Out my RRSP Contribution?
An RRSP only counts as taxable income when you withdraw the money. When you withdraw the money, you pay based on the marginal tax and income tax rates of that period. Since the RRSP is tax-free, many choose to max out their RRSP Contribution.
If you have the means to, the more you put into your retirement savings, the more your money will compound. You are set to have a more stable financial future and retirement income. However, it is important to remember that you will have to pay taxes on the retirement income as well.
For those that can, maxing out your RRSP contribution can get you a hefty tax refund, but as always, be careful not to go over the contribution limit.
A Taxing Decision: RRSP or TFSA?
RRSPs and TFSAs are both tax-free savings options. However, they differ in the features they offer. An RRSP is more of a retirement savings account. Early withdrawals can lead to financial consequences. TFSAs are also long-term investment options. However, they offer a much more flexible withdrawal policy. Unlike RRSPs, TFSAs do not give you a tax deduction.
There are pros and cons to both savings options. Many choose that have both investment accounts gives them the best of both worlds. An RRSP compounds your money over a long period of time and gets you a tax deduction. However, income tax applies when making a withdrawal. There are also consequences to withdrawing early.
A TFSA may have a lower interest rate and does not offer tax savings. However, you can withdraw your money anytime without having to worry about any penalties or taxes.
The Bottom Line
Retirement savings can help you feel financially stable in the future. And there are steps that you can take now to help you make the most of your retirement savings. RRSPs can get a bit confusing with all the limits and rules, but there are many resources to help you. Luckily, in Canada, there is a wide range of investment options that you can take advantage of.