Most US employers provide a retirement plan referred to in financial circles as the 401(k) plan. 401(K) is a contribution plan that offers the participants benefits depending on the amount they contribute, the amounts matched by the employer, and how well the investments they perform over time. The equivalent of 401(k) in Canada is the Registered Retirement Savings Plan (RRSP).
What Is a Registered Retirement Savings Plan?
A Registered Retirement Savings Plan is a financial account in Canada for holding savings and investment plans. The account is tax-deferred and allows Canadians to contribute to their Registered Retirement Savings Plan account up to a maximum limit. The limit is based on the highest percentage of the contributor’s prior year’s earnings and up to a definite dollar maximum limit for contributions. For example, the 2020 limits are 18 percent of the total 2019 earnings with a maximum dollar limit of $27,230. Both employees and the self-employed in Canada can hold an RRSP account.
Similarities Between RRSP and a 401(k)
- Both plans are created and offered by the respective governments.
- They both allow for investments into a diversified investment mix, including CICs, stocks, bonds, and mutual funds.
- Both provide employees in Canada and the US, respectively, a deferred way to make investments and grow their retirement funds.
- Both plans feature an annual contributions limit.
Differences Between RRSP and a 401(k)
- Penalties: Unlike 401(k), the Canadian RRSP does not impose penalties for early withdrawals. In the US, you will be taxed 10 percent for any early withdrawal that you make.
- Use policy: 401(k) uses a “Use It Or Lose It” policy on savings, but any unused RRSP contributions limits are typically carried forward to the next year.
- Extra contributions: 401(k) allows employees to catch up by making higher contributions after they hit 50 years old. This is not the case with the Canadian RRSP.
- Contributions: The contribution amount is also different from each of the plans. In 401(K), one can invest a portion of their salary up to an annual limit. The employer may also match a part of your contribution. You can usually withdraw any of the money without a tax penalty until you are 59.5 years old. For the Canadian plan, until you turn 71, you can contribute up to 18 percent of your previous year’s earned income to an RRSP, taking into account pension adjustments. Ideally, you must close your RRSP once you turn 71. At this time, you can withdraw your RRSP savings in cash (which is subjected to taxes) and convert it to a Registered Retirement Income Fund or an annuity
What Are the Benefits of Canadian RRSP?
There are so many reasons why you should open the Canadian RSSP account:
Tax-Deductible Contributions
Ideally, you can claim your RRSP contributions as a deduction on your tax return. For example, employees at the top bracket will benefit from a tax reduction of $535 for every $1,000 they contribute. You are also allowed to carry forward the deduction for your contribution to the next year if your income is lower in a given year.
Tax-Free Savings
All your investment earnings typically don’t attract any tax as long as you stay with your RRSP. The benefit of this tax-free compounding is that your savings will enjoy some growth. Tax-free compounding also allows your investment to grow without the drag of annual taxes. But you have to appreciate the fact that growth isn’t necessarily massive and often takes a long time. Also, any profits made in the RRSP are tax-free losses and cannot be tax deducted. There are also stringent anti-avoidance rules designed to prevent aggressive tax planning.
Tax-Free Transfer of Savings
Ideally, you are also allowed to move your RRSP savings tax-free into an annuity or an RRIF. However, you will pay taxes on regular payments that you receive each year; however, this doesn’t affect those in a lower bracket in retirement.
The Reduced Combined Tax Burden
If you are taking home more money than your spouse, you can benefit from a reduced combined tax burden by contributing to a spousal RRSP. The retirement income is ideally split equally between the two of you, effectively reducing the total amount of tax that you pay
You Can Borrow From Your RRSP
If you are short of cash and need funds to buy your home or pay for education, you can borrow your RSSP. The Home Buyers Plan allows contributors to borrow up to a maximum of $25,000 for the down payment of their first home. Additionally, you are allowed to take out up to $20,000 to fund your education and that of your spouse using the Lifelong Learning Plan. If you pay back the money within a specified period, no tax will be charged.
Protected From Creditors
RSSP savings are protected from creditors’ claims from lawsuits or bankruptcy. Like a pension, your RSSP will not be used to cover liabilities from either bankruptcy or lawsuits.
Finally, RRSP is one of the three main tax shelters for Canadians. On top of the benefits that we have listed, Canadians typically use this plan created in 1957 to delay taxes. Although the RRSP plan shares many similarities with the American 401 (k), there are also some glaring differences. Contact us today if you are a foreign investor setting up a base in Canada and need help with employees. We will work with you to provide your company with the best package of Employer Services for your Canadian workforce.
