Registered Retirement Savings Plans, commonly known as RRSPs, were first introduced in 1957 to assist self-employed individuals and employees who were not members of a registered pension plan (RPP) to help save for their own retirement. Quite simply, an RRSP is an investment plan registered with the Canada Revenue Agency (CRA), which holds investments for your benefit. That is not to say that RRSPs are only for those who do not already contribute to some other method of retirement savings, like a pension plan. They too may be able to take advantage of the significant benefits that come from contributing to an RRSP.

Advantages of Contributing to an RRSP

There are essentially two significant benefits that make contributing to an RRSP a worthwhile component to your overall financial plan. The first is the immediate tax savings resulting from a contribution to an RRSP. Subject to some limitations that will be discussed later, contributions made during the year and within the first 60 days of the following year can be used as a deduction from income when your tax return is filed. This deduction will result in immediate tax savings equal to your marginal tax rate, which could be as high as 48% (however, this rate will vary by province and income level).

The second major benefit from contributing to your RRSP is the tax-deferred savings. The investments inside the RRSP may earn income such as interest, dividends, or capital gains. However, the earnings inside the RRSP will remain tax sheltered until they are withdrawn from the plan at which time they will be taxable as income. Given that the returns are not taxed inside the plan, this allows for your investments inside the RRSP to continue to accumulate tax-free earnings that will compound the growth of the investment.

Consider this example. Eric has invested $5,000 in a non-registered investment every year, which generates a 5% annual rate of return in the form of interest income. Assume Eric has a marginal tax rate of 46%.

(Please refer to the AIC Tax Rate Card AIC2118 to find marginal tax rates for various provinces).

After 20 years, Eric's non-registered investment after paying taxes on the interest income each year will grow to approximately $130,000, which includes $100,000 in contributions and approximately $30,000 in after-tax savings.

Nancy, on the other hand, has been contributing $5,000 into her RRSP on a yearly basis and is also subject to the same marginal tax rate of 46%. Her investments inside the RRSP are also generating a 5% rate of return in the form of interest income. At the end of 20 years, Nancy's RRSP will have grown to be worth approximately $165,000 consisting of contributions and accumulated earnings. In addition to the value of the RRSP, Nancy would have also received approximately $46,000 in tax savings as a
result of the annual contributions. If the annual tax savings of $2,300 were reinvested in a non-registered portfolio earning the same 5% interest income, then Nancy would have
accumulated an additional $59,950 after tax. Therefore, Nancy's RRSP would have grown to $165,000 plus $59,950 from her tax savings reinvestment for a total value of $224,950. This value compared to Eric's non-registered portfolio will make RRSP investing worth considering.

The Rules

In order to contribute to an RRSP and enjoy the benefits, you should understand some of the fundamental rules so that you can maximize your planning opportunities. In articular, you should understand the maximum you could contribute on a yearly basis, what "earned income" is and what factors affect how much you could contribute to your RRSP We will have a look at each of these here.

RRSP Contribution Limits

The annual maximum RRSP contribution dollar limit had been $13,500 since 1996 and remained the same until 2002. In 2003, the limit increased to $14, 500 and it increased again, to $15, 500 in 2004. In 2005, the limit is set to increase to $16,500 and in 2006 to $18,000. In 2007 and beyond, the contribution limit will be indexed to increase according to the average industrial wage in Canada and therefore, will be adjusted on a yearly basis.

However, the amount that you can contribute to an RRSP every year is limited to 18% of the previous year's "earned income" (subject to the maximum dollar limit mentioned above). Therefore, your maximum contribution limit for 2004, may also be dependent on your 2003 earned income (i.e. reported in your 2003 return).

Earned Income

So what exactly is earned income? For most people who are employees, it is simply their salary or wages before source withholdings. For self-employed individuals, it will primarily be business income. Earned income will also include the following items:

• Research grants, net of deductible expenses.
• Royalties if you're an inventor or an author.
• Rental income (net of expenses) from real estate or from a limited partnership.
• Alimony, maintenance and taxable child support received.
• Disability pension income received under the CPP/QPP

Investment income, such as interest, dividends and capital gains, and severances or retiring allowances, death benefits or income from an RRSP or RRIF are not considered to be earned income and will not create RRSP contribution room.

PA, PSPA and PAR

Once you have your maximum contribution limit calculated, there may be factors that alter how much you can contribute to an RRSP The adjustments to your RRSP contribution limit could be in the form of a pension adjustment (PA), past service pension adjustment (PSPA) or pension adjustment reversal (PAR). These rules can be quite complex, however a basic understanding will help you identify how these will affect your RRSP contribution limit.

These adjustments exist in our tax law to ensure that all Canadians, whether they belong to a company pension plan or not, have an equal opportunity to save for their own retirement. The annual contribution limits will apply to all tax deferred plans and so, if you belong to a company pension plan or a Deferred Profit Sharing Plan (DPSP), your ability to contribute to an RRSP may be affected by these adjustments. Here is a brief summary of what these adjustments are and how they affect your RRSP contribution limit.

Pension Adjustment (PA)

A pension adjustment is subtracted from your RRSP contribution limit and it represents the deemed value of your pension earned for the previous year. Basically, the PA calculates the amount that has already been put aside for you, by you and your employer combined, and reduces this from your RRSP contribution limit. Therefore, if you and your employer already contribute to some tax-deferred retirement vehicle, you will have a pension adjustment that ultimately reduces the amount you can contribute to an RRSP.

Past Service Pension Adjustment (PSPA)

Like a pension adjustment, a past service pension adjustment will also reduce the amount that you could contribute to your RRSP. A PSPA may arise where you are given the opportunity to make contributions to a pension plan for past service. While the rules for PSPAs can be highly technical, essentially any past service contributions for years of service from 1990 onward will result in a PSPA. Past service contribution for years of service prior to 1990 will not result in a PSPA.

Pension Adjustment Reversal (PAR)

The effect of a pension adjustment reversal on your RRSP contribution limit is the opposite to the effects of PAs or PSPAs. The PAR will actually increase the amount you can contribute to an RRSP. A PAR may result if you terminate your employment prior to your RPP or DPSP rights vesting; thereby giving you back some of the RRSP room you lost due to the pension adjustments while you were a member of a company pension or profit sharing plan. It will not be your responsibility to calculate these adjustments, as your pension or profit sharing plan administrator is required to provide it to you.

Too Much - Too Little

Although the RRSP contribution limit calculation can be rigorous, you will be glad to know that the CRA keeps track of it for you and communicates it to you on your Notice of Assessment for each tax year. It is important to keep track of what contribution limits you have on a yearly basis because knowing if you have over-contributed or not used all of your contribution room will have implications for you. So what are the implications of not contributing the maximum each year and what are the implications if you contribute greater than the maximum allowed?

We have discussed how to calculate your RRSP contribution limit for each year. However, there is no obligation to contribute the maximum amount each year. Does this mean you lose any unused RRSP contribution room? Definitely not. If you contribute less than your contribution limit, you are permitted to carry forward any excess contribution room to any future year, with no expiration date.

If you contribute more than the maximum contribution room allotted to you, then you will likely face penalties on any over-contributions. The penalty is 1% per month calculated on the excess contribution. However, there is a buffer which the tax law provides before the penalty is calculated. Every person has a lifetime over-contribution limit of $2,000, which essentially means you could over-contribute by this amount and not face any penalties as long as you were at least 19 years old during the year. The age restriction is designed to prevent parents and grandparents from giving money to minor children and having it grow tax free in an RRSP. While the over-contribution cannot be deducted, it can be deducted in a future year when more RRSP room becomes available.

Special Contributions to an RRSP

In addition to the regular RRSP contributions subject to the limits discussed above, there are special types of contributions that will not affect your own RRSP contribution limit. These special contributions can only be made to an RRSP for which you are the annuitant.

One such example is the contribution to an RRSP if you receive a retiring allowance or severance pay.

When an employee receives a retiring allowance, they may be allowed to transfer a portion of this payment to their RRSP on a tax-deferred basis. The amount that can be rolled over is limited to $2,000 per year or part year of service before 1996, plus
$1,500 per year or part year of service prior to 1989 for which the employee was not receiving employer contributions to a pension plan. In order to have this special rollover provision apply, the transfer must be made within 60 days following the end of the year
that the payment is received.

Some other direct transfers to an RRSP that do not affect your contribution limit:

In certain cases, lump-sum payments from foreign pension plans for services performed outside of Canada;

• Lump-sum payments from a U.S. IRA;
• Amounts received from a deceased spouse's RRSP or RRIF;
• Lump-sum payments from a superannuation or pension plan;
• Lump-sum payments from a deferred profit sharing plan; and
• Lump-sum payments from other registered plans.

Qualified Investments

RRSPs are permitted to hold certain types of investments, known as qualified investments. Some of the more common types of investments that are "qualified" for RRSPs include:

• Units of a mutual fund
• Shares and debt obligations of corporations listed on a prescribed stock exchange in Canada
• Shares listed on a prescribed stock exchange outside of Canada
• Shares of the capital stock of certain private corporations
• Government-issued debt obligations
• Canadian currency
• GICs issued by a Canadian trust company
• Mortgages on real property

It's important to ensure that your investments inside your RRSP are qualified investments and remain qualified inside your RRSP. The reason is that there are penalties for holding investments that are non-qualified. It is possible that an investment, which was qualified when first placed inside the RRSP, later becomes a non-qualified investment for RRSP purposes. For example, you could have invested in a share of a company which was listed on a prescribed stock exchange at the time you placed it in your RRSP. However, later it became de-listed from that stock exchange, resulting in your RRSP now owning a
non-qualified investment.

Foreign Content

In a perfect world, you should be able to choose which investments you would like in your RRSP. However, the tax law imposes rules, which state exactly the maximum amount of foreign property that can be held inside your RRSP, therefore limiting your ability to diversify.

The foreign content limit is currently 30%, meaning that an investor could own no greater than 30% of the cost base of investments in an RRSP in foreign property. Penalties will apply to those who exceed this threshold. For some investors who wish to invest more than 30%, there are some clever methods to artificially increase foreign content inside an RRSP.

One method is by investing in RRSP-eligible clone funds. Clone funds essentially invest in units of an underlying foreign fund using derivative investments that are Canadian in nature. This structure allows an investor to get the same investment exposure, as he or she would have had if an investment had been made directly in foreign securities and have it treated as Canadian content for RRSP purposes. By investing in RRSP clone funds, you could achieve a greater geographical diversification without exceeding the foreign content restriction. Your own financial advisor or Fiscal Agents can provide you with more information about how RSP clone funds that can increase your exposure to foreign investments inside your RRSP.

Spousal RRSPs

A spousal RRSP is one in which you contribute to an RRSP for your spouse and claim the deduction for yourself. This can be an effective method for income splitting where one spouse is currently in a higher tax bracket than the other. There are essentially two significant benefits to contributing to a spousal RRSP:

• -The spouse contributing to a spousal RRSP (who is in a higher tax bracket) receives a deduction for the contribution to a spousal plan; and
  
  
• The annuitant spouse (who is in the lower tax bracket) will ultimately be taxed on the
  withdrawals from the plan at a lower marginal tax rate, subject to certain limitations.

Any income from a spousal RRSP will be taxed back to the contributor where amounts contributed are withdrawn by the spouse in the year of the contribution or in the following two calendar years.

Conclusion

Some may argue that the investments inside the RRSP are fully taxable when they are withdrawn and therefore an RRSP is not a worthwhile investment vehicle. While all withdrawals from an RRSP are taxable, it is rare that your entire RRSP will be withdrawn at once. The real benefit from RRSP investing is that, even after retirement, RRSP investments (which eventually can be converted to RRIFs) continue to benefit from compounded tax-deferred growth, as only the portion withdrawn will be taxable.

RRSPs represent one of the most common and easiest ways to shelter income from tax for an extended period of time and can play an important role in achieving your retirement goals. Speak to a Fiscal Agents or a qualified financial advisor about your RRSP to assist you in reaching your retirement goals.

Definitions:

CRA - Canada Revenue Agency
RPP - Registered Pension Plan
PA - Pension Adjustment
RRSP - Registered Retirement Savings Plans
RRIF - Registered Retirement Income Fund
DPSP - Deferred Profit Sharing Plan
PSPA - Past Service Pension Adjustment
PAR - Pension Adjustment Reversal
PSPA - Past Service Pension Adjustment

More information and resources

RRSP Learning Centre
RRSP Special Section
RRSP Deposit interest rates
RRSP calculators

Please Note: Canadian provinces and territories impose their own tax rates in addition to the federal tax rates. Therefore, depending on where an investor lives, that individuals tax rate may differ from any examples shown. The content of this bulletin is for informational purpose and in no way should be construed as tax advice. Please consult a professional tax advisor for tax advice related to your specific situation.