Your Employment Status and Your RRSP

By Mark Swartz, MBA, M.Ed.

Monster Senior Contributing Writer

Did you know that you can take up to 18% of the income you earn each year and place it in an RRSP (Registered Retirement Savings Plan), thereby sheltering this money from taxes until you withdraw it later in life, while also receiving a tax deduction for each year you contribute, all the way up to and including age 71?

Back in 1957, Canada’s federal government established RRSP’s to encourage people to save for their retirement. Not only can you contribute yearly to your own plan, but to your spouse’s plan as well – part of a strategy known as retirement income splitting, which can result in substantial tax savings. And if at some point you find yourself under financial strain from being unemployed, you may be able to withdraw a portion of your RRSP funds at a lesser tax rate than if you were receiving your full income.

Tax Deferral, Tax Sheltering, and Tax Deductions Explained

The three primary benefits of placing your savings into an RRSP are as follows:

Tax Deferral – You can put off paying taxes on the funds you put into an RRSP until you withdraw them at a much later time. The idea here is that once you reach retirement age (or age 72 as the current RRSP rules state), you will likely be earning less than your peak pay, so when you start taking out your money you will be at a much reduced marginal tax rate.

Tax Sheltering – While your savings are inside your RRSP, they generate interest that is tax free. This enables your savings to grow considerably faster than if they were being taxed each year.

Tax Deductions – Each year that you contribute to an RRSP, you are entitled to a tax deduction for that same year. For example, Shahla is showing earned income of $40,000 this year. She can place up to 18% of this amount, or $7,200, into her RRSP. By doing so, she can claim a deduction on her income tax for this same amount; thereby, lowering the total income tax she will have to pay this year.

RRSP Contribution Limits and “Earned Income”

The maximum RRSP contribution amount that can be deducted in a given year is called the "RRSP deduction limit", also known as "contribution room" or "deduction room". Your deduction limit is found on your Notice of Assessment or Notice of Reassessment from Canada Revenue Agency. Your 2010 limit would be on your 2009 Notice.

A nice feature of RRSP’s is that unused deduction room can be carried forward from the previous years. However there is a yearly maximum amount that you can contribute to RRSP’s under your name.

Any person who is 71 years old or younger can contribute to an RRSP, up to the maximum annual amount, so long as you can show earned income for that year. Earned income includes revenue from employment or regular wages, net business income if you are self-employed, or net rental income. Note that Old Age Security benefits, Canada Pension Plan payments, or Employment Insurance Benefits are not considered to be earned income, though they may be taxed as part of your overall income.

Your Employment Status and How It Affects Your Retirement Savings

If you are currently employed, and you can afford to contribute to an RRSP, then you might be well advised to do so. The immediate tax savings and future income that gets taxed at a lower rate make it an attractive proposition. If you happen to be unemployed, there are several ways that RRSP’s may benefit you.

In the first case, let’s assume that you have been sheltering money within your RRSP for at least one year. Should you then find yourself unemployed and struggling financially, you can withdraw up to the full amount in your RRSP either immediately or gradually, to help out with such urgencies as paying the rent, mortgage, or other such obligations. Your RRSP withdrawals will be taxed in that fiscal year at your highest marginal tax rate treated as if it were just another source of income.

The other way that RRSP’s can come in handy when unemployed is if you receive a “severance payment” when you are downsized from your job. Normally the severance funds would be taxed in full during the year they are received. However there are two methods of sheltering a portion of this money in an RRSP.

One is to simply treat your severance pay as a form of employment income. It will be taxed at its source; that is, your employer will deduct the normal amount of taxes before you receive your funds. Come the end of the fiscal year, you can put as much of the remaining severance into your RRSP as your contribution room allows.

Or, if your (former) employer allows it, you can get them to directly contribute a portion of your severance into your RRSP, thereby avoiding pay deductions like income tax, Canada Pension Plan premiums, and Employment Insurance premiums. The amount that is eligible for direct deposit is based on your years of service to the firm and other factors.

Don’t Defer Your Decision

Regardless of your employment and financial situation, you should consider saving for your retirement as early as possible. This gives you the maximum tax sheltering in the long term, lets your savings grow faster than if unsheltered, and provides you with a tax deduction each year that you contribute.

Make sure that you work with a good financial planning professional and tax accountant when deciding on how to proceed. They can clarify the many ins and outs that apply to your specific circumstances and financial goals.

But don’t delay: March 1st is the annual deadline for RRSP contributions that will be applied to the previous year. Miss the cut-off date and you’ll have to wait another 12 months before you can benefit from sheltering your money in a registered retirement savings plan.