RRSP: Really Radical Savings Plan?
By: Ken Lee | KLee Tax and Financial Services Co.
Published: 7 April 2025 4:00AM EST (Updated 7 April 2025 4:02AM EST)
Photo Credit: CPA Canada
All references to the ‘Act’ mean the Income Tax Act, RSC 1985, c. 1 (5th Supp.), as amended. All references to the ‘Regulations’ mean the Income Tax Regulations. The following should not be construed as legal nor tax advice. Consultation with your usual tax/legal professional is advised.
Before we start, you may find these words helpful:
- GICs - Guaranteed Investment Certificate: A type of term deposit
- ITA - Income Tax Act: The penultimate (and very long) law that dictates the rules and collections of taxation in Canada.
- LIRA - Locked In Retirement Account
- RDSP - Registered Disability Savings Plan
- RRSP - Registered Retirement Savings Plan
- RRIF - Registered Retirement Income Fund
- RSP - Registered Retirement Plan: An umbrella term for any retirement account
- TFSA - Tax Free Savings Account
Good morning, Toronto! Now that tax season is underway, it’s never too early to start planning for future tax years. This article will cover some of the keystones of retirement planning and how we can factor these tools into tax planning. Namely, we will discuss how various RSPs work and the rules governing their use.
First, the RRSP. The RRSP is tax-deferred – you are not taxed on any capital gains until you withdraw from it, in which case it is taxed as if it were employment income. In December of the year you turn 71, you must convert the RRSP to an RRIF and draw down at least the minimum percentage (based on your age) annually.
An RRSP is an account which works like any other investment account. You can elect to have it managed by a professional (with very high fees), or by yourself. Regardless, you can hold multiple types of investments in an RRSP, including but not limited to GICs, securities on a stock exchange, mutual funds, bonds, etc.
Note that securities on a stock exchange are a wide term that encompasses many types of investments, such as shares of a corporation (stocks), calls, and warrants. Together, securities (along with the abovementioned investments) make up ‘qualified investments’, or investments that are allowed to be held in any registered plan – like an RRSP, TSFA, RESP, or RDSP. However, ITA §207.01(1) provides that certain shares of a corporation can become ‘prohibited investments.’ According to the CRA:
A share of a corporation is a prohibited investment for a plan if [...] the controlling individual of the plan is a specified shareholder of the corporation or [...] does not deal at arm’s length with the corporation
– ¶1.59, Income Tax Folio S3-F10-C1, Qualified Investments
For §207.01(1), if you are a ‘specified shareholder,’ you usually have a significant interest in the corporation. Generally, this means that you own more than 10% of a corporation. But, the CRA further provides that:
For purposes of this test, a taxpayer is deemed to own the shares of a corporation that are owned by persons with whom they do not deal at arm's length.
– ¶2.8, Income Tax Folio S3-F10-C2, Prohibited Investments
Now, one of the interesting parts of Canadian Tax Law is that the system doesn’t just look at your ownership on paper – it also takes into account your relationships. To greatly simplify the rules (which would be a separate article!), if you are related to someone by blood or by law, ITA §251(1)(a) provides that you do NOT deal at arm’s length with a party, and their share ownership will be added to yours to determine if it's prohibited.
In the event an investment is deemed to be ‘prohibited’, the penalty is 50% of the Fair Market Value (FMV – the fair value of an investment) at the time of the acquisition, and 100% of ALL growth.
Let’s apply this in an example: Sophie has an RRSP and bought 1% of Fine Canadian Lapel Pins Corp for $100. These shares are now worth $200. Separately, Sophie’s mom and dad each own 5% of the shares in the corporation. Under §207.01, Sophie would be deemed to ‘own’ 11% of the shares of the company (her shares, plus the shares of both parents), triggering the prohibited investment tax. She would be liable for 50% of the FMV of the shares on the date she bought them ($50) and 100% of the growth on those shares ($100), for a total penalty of $150.
Let’s also consider the contribution limit. The contribution limit is 18% of your earned income during the last tax year, to a maximum limit of $31,560, with this amount being indexed to inflation. Earned income includes employment income, self-employment income, and net rental income, among others, but excludes passive income and income from a pension.
However, this contribution limit will be reduced by any retirement benefits through your employer. Most workplaces usually offer employees a Defined Contribution (DC) or Defined Benefit (DB) scheme. With a DC plan, your employer will match a percentage of each dollar you contribute to an RRSP, up to the limits as described above. You then choose the investments, and you’ll have a lump sum at retirement. As a side effect, the amount you will receive at retirement can vary based on market conditions.
DB plans are somewhat more straightforward in that your employer will pay you a fixed, guaranteed, monthly payout based on your years of service and best earning years. That said, DB plans are more costly for the employer and shift the risk of managing the investment to the employer. These days, most employers only offer DC plans, with DB plans being exceedingly rare outside of the civil service.
With a DB or DC plan, your RRSP room will be reduced accordingly. In a DC plan, the reduction is the total that you contributed and that your employer matched. For DB plans, this reduction is called a Pension Adjustment (PA). Due to the variations in how each pension is managed, its calculation is not as straightforward – you should consult with your employer for more information. Nonetheless, there are situations in with your PA is more than what your RRSP room what be. In this case, your RRSP room does NOT decrease (contrary to popular belief) - it simply stays the same.
That said, DC pension plans offer significantly higher flexibility when choosing to leave your employer. If you left (or were terminated) by your employer and had a DB pension, you have a few choices. If you are ready (and eligible) to retire, you can elect to immediately start taking your pension. Otherwise, you may be eligible to transfer your years of service to another pension plan (if your new employer also offers a DB pension) or take the commuted value – the lump-sum equivalent of what your future pension would pay – and transfer this into a LIRA. LIRAs are restricted versions of RRSPs which only allow withdrawals pre-retirement under very strict circumstances.
Let’s put it together. Sabine is a COO at Great Canadian Cards LLC. Her total salary in 2024 was CA$168k. She also had rental income of $25k, with $5k in costs. Her employer offers a DB pension, and her PA was $30,000. Therefore:
- Her net rental income is $20k, after subtracting expenses
- Her earned income for RRSP purposes is $188k.
- Her unreduced contribution rate would be $31,560 (18% of 188k is $33,840, but this is reduced to the maximum of $31,560)
- After the PA, Sabine can contribute $1,560 to an RRSP in 2025.
Excess contribution room can be carried forward, meaning if you do not fully contribute to an RRSP in one year, you can ‘make up’ the contributions in future years. Likewise, to sweeten the deal, these contributions are tax deductible*, reducing your taxable income for provincial and federal tax purposes. These tax deductions can also be carried forward. This carry forward is an important concept in tax planning because depending on your income bracket, this can have a significant effect on how much tax you save.
*Note: Only the portion you contribute is deductible in a DC pension scheme. If you have a DB pension, your deduction is your PA. PAs CANNOT be carried forward.
With that, meet Emily and Michelle. They made $60k and $160k, respectively, last year, and both of them contributed 10k to their RRSP. Let’s pretend that EI/CPP do not exist – we will just look at their tax liability. All else being equal:
- Emily would usually owe $9,083 in provincial and federal taxes, and Michelle would usually owe $46,056. (Remember, Canada has a progressive system that taxes based on the portion of your income that is in each bracket.)
- After RRSP contributions, Emily’s taxes are now $6,526, and Michelle’s are $41,573
- Emily and Michelle saved $2,557 and $4,483, respectively – despite each having contributed the same amount.
The takeaway? If you want to best maximize growth and tax deductibility, invest in an RSP NOW, and claim the deduction later when your income is in the higher tax bracket.
To sum up: Retirement planning starts early! It is important to invest early to maximize your future returns! Even though you may not have taxes to pay, it is a good idea for everyone to report their income and build up their RRSP room early!
A bit about us: KLee Tax specializes in filing tax returns for individuals, businesses, and corporations. Whether you are working your first job, running a business, or an NPO looking to make a difference, you can be sure that KLee Tax will be there for your tax needs, when and where you need us.
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