RRSP

Registered Retirement Savings Plan

A Registered Retirement Savings Plan (RRSP) is another type of investment account available in Canada that is designed to help individuals save for retirement. The special thing about RRSPS is that Contributions to an RRSP are tax-deductible, which means they can be used to lower an individual's taxable income in the year the contributions are made, which will lower your taxes owing to the government. However in terms of income, Any capital gains, dividends, or interest earned within the account are not subject to taxes until the funds are withdrawn by you in the future, at which point they are subject to taxes and considered as income.

There is also a contribution limit for an RRSP account and it  is based on a percentage of an individual's income, as determined by the Canadian government. The contribution limit is calculated as being the lesser of the dollar limit and 18% of prior year Earned Income. For 2022, the dollar limit is $29,210. Earned income refers to employment income, business income, rent from real property and royalties if taxpayer is author or inventor

What happens if you over-contribute to your RRSP?

The CRA provides Canadians with a lifetime over-contribution exemption of $2,000. For example, if you have contribution room of $4,000 and put $6,000 into your RRSP, you’ll have used up both the room available plus all of the excess amount.

Although you’re permitted to make the small over-contribution, you’re not allowed to claim it as a tax deduction. While the CRA allows you to over-contribute by $2,000 over the course of your lifetime, you’ll have to pay a financial penalty if you go over that amount. It’s up to you to make sure you don’t go over the limit.

If you do exceed the over-contribution limit, you’re subject to a penalty of 1% per month on the excess amount. For instance, an individual who makes a contribution $20,000 over the limit will be subject to a fine of $200 per month or $2,400 annually.

Excess contributions remain in the RRSP until they’re withdrawn or until they’re reduced by new contribution room. You’ll be subject to the 1% monthly fine until you accumulate enough new contribution room and the over-contribution is cancelled out.

What to do if you over-contributed to your RRSP

If you expect the following year’s contribution will use up the excess contribution, you can simply pay the 1% tax. To do this, you must submit a T1-OVP form to the CRA. The form is due—along with payment of the penalty tax—no later than 90 days after the end of the year. Failure to file may result in additional penalties.

The other option is to withdraw the excess contribution and ask the CRA to waive the withholding tax. If you go this route, you need to first file what’s known as a T3012A form.

RRSP VS TFSA

In this blog, we'll be explaining the difference between TFSA and RRSP and looking at three main decision points to help you choose what's most optimal for yourself.

First off, what is a TFSA, and what is an RRSP?

A Tax-Free Savings Account (TFSA) is a type of investment account available in Canada that allows individuals to save, invest, and earn income tax-free. Contributions to a TFSA are not tax-deductible, and any capital gains, dividends, or interest earned within the account are not subject to taxes when withdrawn. Sounds great, right? Why not always just invest within your TFSA if you'll never pay taxes on income earned in this account? Well, for two reasons:

1. there is an annual contribution limit for a TFSA which is determined by the Canadian government and changes from year to year. The good news is it's a very high limit.
2. You also have the opportunity to invest in an RRSP instead.

So what is an RRSP?

A Registered Retirement Savings Plan (RRSP) is another type of investment account available in Canada that is designed to help individuals save for retirement. The special thing about RRSPs is that contributions to an RRSP are tax-deductible, which means they can be used to lower an individual's taxable income in the year the contributions are made, which will lower your taxes owing to the government. However, in terms of income, any capital gains, dividends, or interest earned within the account are not subject to taxes until the funds are withdrawn by you in the future, at which point they are subject to taxes and considered as income. There is also a contribution limit for an RRSP account, and it is based on a percentage of an individual's income, as determined by the Canadian government.

In summary, a TFSA is a tax-free savings account, contributions are not tax-deductible, but withdrawals are tax-free. An RRSP is a registered retirement savings plan, contributions are tax-deductible, but withdrawals are subject to taxes.

So which one should you use?

1. We'll start by assessing your overall investment objective and what you want to achieve with your money.
2. Then we'll discuss your tax situation and how that impacts which account may be more beneficial for you.
3. Lastly, we'll talk about additional factors related to dividends and withholding tax on dividends when choosing which investments may be more beneficial in each account.

Overall Investment Objective

Your overall investment objective is important because deciding to invest in your TFSA or RRSP will influence how and when you have access to investing, liquidating, and just managing your investments. It's important to ask yourself what your goal is with the money and whether you have a short or long-term outlook. If you need access to the money soon, the TFSA may be the better option as it's more flexible, and you can take money out and put it back in without losing contribution space. I should caveat that although TFSA is more flexible in respect to withdrawals - when contributing and withdrawing from both RRSP and TFSA, it's important to understand the rules for contribution room - as the penalties for over-contribution within both accounts do exist. On the other hand, if you're willing to lock away money for the long-term, the RRSP may be a better choice, especially if you're currently in a high tax bracket. So when determining whether you'd like to go the TFSA or RRSP route, first consider your objective as an investor.

Your Tax Situation

Secondly, your tax situation is an important factor. If you're in a high tax bracket, using your RRSP is a great way to get the most bang for your buck by saving on taxes at your marginal rate. The RRSP is a great savings account even if you're not making a lot of money because it allows you to defer taxes.

Let's discuss the mechanics of each account.

A Tax-Free Savings Account (TFSA) is a type of investment account available in Canada that allows individuals to save and invest money tax-free. Contributions to a TFSA are not tax-deductible, but any capital gains, dividends, or interest earned within the account are not subject to taxes when withdrawn. The annual contribution limit for a TFSA is determined by the Canadian government and changes from year to year.

A Registered Retirement Savings Plan (RRSP) is another type of investment account available in Canada that is designed to help individuals save for retirement. Contributions to an RRSP are tax-deductible, which means they can be used to lower an individual's taxable income in the year they are made. Any capital gains, dividends, or interest earned within the account are not subject to taxes until the funds are withdrawn, at which point they are subject to taxes as income. RRSP contributions have limits. The contribution limits are based on a percentage of an individual's income, and that percentage is determined by the Canadian government. The contribution limit for the current year and the previous year for each individual is different and can be found on your Notice of Assessment from the Canada Revenue Agency.

In summary, TFSA is a tax-free savings account, contributions are not tax-deductible but withdrawals are tax-free. RRSP is a registered retirement savings plan, contributions are tax-deductible, but withdrawals are subject to taxes.

Contributions made to an RRSP are tax-deductible, which means they can be used to lower an individual's taxable income in the year they are made. When an individual makes a contribution to an RRSP, they are given a tax receipt that can be used to claim a deduction on their income tax return for the year. The amount of the deduction is equal to the amount of the contribution.

For example, if an individual earns $50,000 in a year and contributes $5,000 to their RRSP, their taxable income for the year will be $45,000 ($50,000 - $5,000). This can result in a lower tax bill for the year. Remember there is a contribution limit, though.

It's also worth noting that if an individual doesn't use all of their contribution room in a given year, they can carry forward the unused portion to future years.

Once an individual reaches the age of 71, they are required to either convert their RRSP into a Registered Retirement Income Fund (RRIF) or to withdraw the funds from the account. At that point, withdrawals from the RRIF will be taxed as income. But potentially, since you're retired and not earning income, you'll be in a lower tax bracket, making your RRSP withdrawals taxed at a lower rate.

Another great advantage of the RRSP account is the home buyers plan and lifelong learning plans which can have the added bonus of helping you well before retirement as well.

The Lifelong Learning Plan (LLP) in Canada is a program that allows individuals to withdraw money from their Registered Retirement Savings Plan (RRSP) tax-free to finance full-time training or education for themselves or their spouse. To be eligible, the individual must be a resident of Canada and have an RRSP. The money withdrawn must be used to finance the education or training within a certain period of time, and any unused funds must be repaid to the RRSP within a certain period of time.

Essentially, when you contribute to your RRSPs you have the ability to use your money tax-free for a period of time to finance your education or purchasing your first home. Keep in mind that these funds must eventually be paid back into your RRSP to ensure you're not taxed on it. However, the advantage here is using your RRSP funds tax-free and temporarily to finance these life choices without having to pay taxes on the financing. It's almost like a loan from your RRSP account to yourself.

So if you're looking to lower your tax bill for the year and have money to invest, RRSP is a great option. However, if you're just starting out and expect your income to increase in the future, it may be better to wait to use your RRSP when you're in a higher tax bracket. The idea here is that it's better to use up your RRSP contribution room when you're in a higher tax bracket as opposed to when you're in a lower tax bracket, to yield the highest possible savings in your RRSP contributions over the span of your life.

Additional Factors

Lastly, this one is a little more technical but if you're planning to invest in US and Canadian stocks, one additional factor that may be useful is how they're taxed when you receive dividends. Consider that if you hold US dividend-yielding stocks in a TFSA, the dividends are subject to a 15% withholding tax, but if you hold them in an RRSP, the dividends are not subject to that tax. An important caveat is that Canadian mutual funds and exchange-traded funds (ETFs) that own US stocks are considered Canadian investments and subject to 15% withholding tax. If you own these in your RRSP, they will not qualify for the 0% withholding tax rate. This is because the mutual fund or ETF is considered the shareholder of the US stocks, not you or your RRSP.

So if you're a hardcore investor with US and Canadian stocks, consider taking advantage of both RRSP and TFSA at the same time, especially when considering the types of securities you hold in each account as there could be some benefit to planning your investment strategy around these tax implications by holding US stocks in your RRSP account and Canadian stocks in your TFSA.

Overall, both the TFSA and RRSP accounts are great tools for Canadians to make smart investments, and both can really help you plan for your future. It's important to note that it's not necessary to invest in TFSA or RRSP to be successful and when investing in your future, so don't get stressed out if you're not taking advantage of them right now - but know that they are great tools that are at your disposal to help improve your financial situation and help you be more financially successful even if you're traditionally more of a real estate investor or entrepreneur. And if you keep that mindset that these are tools that can only help you improve, it'll give you a positive outlook on the options you have for investing in your future, making sound financial decisions, and who knows, maybe you'll end up being as excited about Canadian tax as we are here at Osman Accounting.

As always, Osman Accounting is here to assist you in navigating the intricacies of the tax system and ensuring that you benefit from our expertise and advice - reach out to us if you have additional questions about the tax implications related to your investment decisions.