The RRSP is fast approaching its 60th birthday. There have been many changes over that period and Canadians’ contributions have ebbed and flowed along with income growth, demographic changes and various tax changes.
A history of the RRSP
When the RRSP was created in 1957, contribution limits were 10% of the previous year’s income to a $2,500 maximum. If an individual did not contribute in any given year, that year’s contribution room was gone forever. Canadians were underwhelmed. In 1968, the first year contribution data was available, only 172,000 contributed.
By contrast, 1990 was a huge year for RRSPs. Contribution limits increased to 18% of the previous year’s income, the dollar limit was raised to $11,500 and the contribution carry-forward rule was introduced, allowing unused room to be carried forward seven years.
In 1996, the government starting indexing the dollar limit to annual wage growth. And the Pension Adjustment was introduced to level the playing field for contributors with employer pensions and/or deferred profit sharing plans (DPSPs). Finally, the seven-year carry-forward rule was replaced with an indefinite carry-forward.
The RRSP’s competition
Today, the RRSP is being challenged on two fronts. First, the TFSA, introduced in 2009, has given Canadians a flexible savings option that avoids tax on income and withdrawals, and that can be used for any savings purpose.
Second, business owners must be paid a T4 income (i.e., salary) in order to be eligible to contribute to RRSPs, but the tax benefits of being paid dividends and investing within a corporation can be more attractive. As a result, many owners are forgoing salary and thus choosing not to contribute to RRSPs.
These headwinds mean that only about 6 million Canadians, or 23% of tax filers, use RRSPs. This proportion has remained fairly consistent since 2009.
Yet the RRSP is still here, 60 years later.
Why the RRSP is great
As of 2014, roughly 24 million Canadians have combined RRSP room of more than $951 billion. That’s approximately $39,628 of unused room for every tax filer. Further, the median annual RRSP contribution is only $3,000. This presents a big tax savings opportunity that simply can’t be ignored – but how big?
Let’s do some simple math. The median marginal tax rate in Canada (combined federal and provincial) is currently 35.32%. If Canadians en masse maximized their RRSPs, this could generate a combined tax savings of $336 billion, or approximately $14,000 per Canadian.
Sure, not everyone is eligible to contribute or has the funds to do so. But no other tax-planning strategy combines simplicity with tax savings quite like the RRSP.
But wait, there’s more.
Other benefits of an RRSP include:
- Encourages long-term savings. The taxation of RRSP withdrawals can create a disincentive to use RRSPs for short-term needs and create a larger future nest egg when compared to a TFSA that can be tapped into at any time without tax costs.
- Canadians retire with lower income. Most retirees are in a lower tax bracket during retirement than during their working years. As a result, the net tax savings (tax deduction at a higher tax rate than the tax rate applicable on withdrawals) can garner higher asset balances in an RRSP as opposed to a TFSA, all other things being equal.
- Tax-deferred growth. The balance grows on a tax-deferred basis in an RRSP as opposed to being taxable annually when money is invested within one’s corporation or taxable account.
- Possible employer contributions. Employer RRSPs often mean matching contributions. I’m a big fan of free money, and every bit counts.
- U.S. tax reporting exemptions. For U.S. persons living in Canada, RRSPs are exempt from Passive Foreign Investment Corporation reporting. They are further exempt from Form 3520-A (annual information return of foreign trust with a U.S. owner). Finally, under the Canada-U.S. Tax Treaty, they are recognized as tax-deferred accounts for U.S. tax purposes. If your clients’ U.S. tax reporting is up to date, this election is now automatic.
In recent years, the RRSP has lost some shine as new accounts and strategies have been introduced. But you have to admire the longevity of the RRSP. Sixty is a big milestone. And it has evolved in major ways since creation to remain a viable option for retirement savings.
Maybe it is the nostalgia talking, but we should make 2017 the year of the RRSP. Tell clients to let their RRSPs help them celebrate this momentous occasion with the best gift of all: cash. Then, suggest they pay down their mortgages, contribute to TFSAs or RESPs, or take vacations.