by Nilay Savla | Oct 15, 2024

Retirement savings are essential for all Canadians to live comfortably after they retire. And the earlier you start saving, the better. For newcomers, understanding retirement savings options can be confusing. So in this article, I’ll demystify the Registered Retirements Savings Plan (RRSP). With a clear understanding, you can start saving as soon as possible to achieve your dreams and goals in Canada!

An RRSP is a tax-deferred retirement savings plan. This plan encourages you to save in your earning years so that you can have income in your retirement years.

The term “tax-deferred” means that when you open an RRSP and contribute to it, you can claim a deduction from your income. And any income earned in the RRSP remains tax-free unless you make a withdrawal from your RRSP. In other words, you defer or delay taxes until the time you make any withdrawal. Therefore, you can defer income taxes until later when you may be subject to lower taxes as your income goes down.

During the years when you earn a high income, you are subject to higher tax rates. So, contributing to an RRSP will help you lower your tax liability. 

You are eligible to open an RRSP if you satisfy these conditions and you:

• Have “earned income” from the previous tax year

• Reported the earned income to the Canada Revenue Agency (CRA) on your tax return

• Have not yet turned 71 years of age.

You can open multiple RRSP accounts. However, it will be easier to manage one RRSP account rather than tracking several accounts.

You can set up an RRSP through a:

• Bank

• Credit union, or

• Trust or insurance company.

Computing the maximum RRSP contribution for the current year involves four steps.

Calculate 18% of the income you earned in the previous tax year. Add the following income to determine your earned income:

• Your employment income. Calculate this as taxable benefits minus union or professional dues.

• Net amount of rental income from renting real property. No other property income will be considered in computing earned income.

• Net amount of self-employment income.

• Research grants received or royalties received from your own invention or published work.

• Spousal support payments (alimony/maintenance) received due to a court order.

• Canada Pension Plan or provincial disability pension plan income received.

• Supplementary employment insurance benefits that the employer pays to you. A good example is the top-up payments (i.e. the difference between your salary and the amount that is paid by employment insurance) that your employer may pay during maternity or parental leave. Do not count any employment insurance benefits that you received from Employment and Social Development Canada (ESDC).

Less: Spousal support payments made.

No other income or capital gains will be considered as earned income for an RRSP. 

Now multiply your earned income by 18%.

Visit www.canada.ca to find out the contribution limit for the current year.

In 2024, the website shows that the annual RRSP contribution limit is $30,780 (for tax year 2023).

Compare 18% of your earned income for the previous tax year as computed in step one and the annual contribution limit determined in step two.

Take the lesser of these two amounts.

To the lesser amount that you determined in step three, add unused RRSP contribution room from the previous years that were carried forward to the current year.

Now, subtract the:

• Previous year’s pension adjustment (PA)

• Current year’s past service pension adjustment (PSPA). 

Now, you have arrived at your maximum RRSP contribution for the current year. The maximum RRSP contribution is also known as:

• Contribution room

• RRSP deduction limit, or

• Deduction room.

If you participate in a registered pension plan or a deferred profit-sharing plan, you earn pension benefits. This is the amount of PA.

In simple terms, PSPA is the amount of extra pension credits you get when either there is:

• An upgrade in your pension benefits or

• A pension buyback.

In a pension buyback, you pay a fixed amount to purchase years of missed pensionable service to enhance your retirement pension. For example, you can miss pensionable service years when in your earning years you: 

• Took a leave of absence or time off your work or

• Deferred the decision to join your employer’s pension plan.

Thereby losing the opportunity to accumulate years of service in the pension plan.

The amounts of PA and PSPA go on to reduce your maximum RRSP contribution amount for the current year. 

Let’s say you want to determine your maximum RRSP contribution for 2023 and you earned:

• $90,000 in employment income and

• $1,000 in taxable capital gains in the previous tax year (i.e. 2022).

• At the beginning of 2023, you have unused RRSP contribution room from previous years that total $7,000.

• As a member of a registered pension plan, your pension adjustment for 2023 amounts to $3,000.

To compute the maximum RRSP contribution follow these four steps:

Compute 18% of your earned income. In your instance, earned income will be $90,000. Taxable capital gains are disregarded while computing earned income. Thus, 18% of your earned income = 0.18 x 90,000 = $16,200.

On www.canada.ca, you find the RRSP dollar limit for 2023 is $30,780.

Take the lesser of the above two amounts. The lesser amount = $16,200.

To $16,200, add the unused RRSP contribution of $7,000 and subtract your pension adjustment amount of $3,000.

So, your maximum RRSP contribution = $16,200 + $7,000 – $3,000 = $20,200.

Let’s take the above example. Since we worked out that your maximum RRSP contribution is $20,200, this is the maximum that you can contribute in the current year (in this case, 2023).

You contribute an excess amount of up to 2,000 without any penalty. But, any amount beyond $2,000 will be subject to a penalty of 1% of the excess beyond $2,000 for each month (or part of the month) that this excess contribution exists. For example, if your maximum RRSP contribution is $20,200, you may contribute:

$20,200 + $2,000 (excess amount not subject to penalty)

However, if you contribute, say, $23,200, there will be a penalty as computed below.

Split the amount of $23,200 as shown:

1. $20,200. This will not attract any penalty.
2. An excess amount of $2,000 which escapes any penalty.
3. An excess amount of $1,000 (which is beyond the excess amount mentioned in 2 above). This excess of $1,000 will attract a penalty of 1% for every month (or part of the month) that it remains in the RRSP.

Thus, you will pay $10 (i.e. 1% of $1,000) as a penalty for each month or part of the month that this amount remains in the RRSP. 

If you make an excess contribution, make sure to withdraw it immediately to reduce the penalty as much as you can. Besides, you are not allowed to deduct from income any excess contribution. It, therefore, helps to avoid making excess contributions in the first place.