How are retirement accounts taxed in Canada?

Not all retirement accounts are created equal. That means not only will you have options but you’ll also find a certain retirement account more suitable than the rest. And when you’re on this journey of discovering your optimal retirement account, it’s important to ask this very question: how are retirement accounts taxed? Knowing how your savings will or won’t be taxed, as well as how much you can contribute and how you can invest the funds you do contribute will help you make this all-important decision.

The value of a retirement account

We’ll spare you most of the soapbox version, but feel obligated to stress the importance of saving for retirement. The various types of retirement accounts available to Canadians make it rather painless to save and invest funds that will support you later in life. And you will need funds to support you later in life.

Even if you plan on working until the moment you kick the bucket, you aren’t always in control. Your company could encourage you to leave at a late age, you could find yourself needing more time to care for a sick family member or young grandchildren, or your health could prevent you from continuing at full steam. And these are just the reasons you may be forced into retirement. Many people willingly choose to go into retirement to free up their schedule to travel, indulge hobbies, hang out with their family more, or just escape a tiring and taxing occupation.

The great benefit of a retirement account is that it gives you the freedom to spend your later years (or middle years, if you use the FIRE method) as you wish. A retirement account won’t just be sitting there waiting for you when you’re ready, though. No, you need to create and fund an account as young as possible in order to have the money you’ll need when you retire.

Part of the value of investing money using a designated retirement account, rather than a regular money market account is that retirement accounts have certain tax advantages provided by the Canadian government. Let’s explore the various options for retirement accounts and how the way they are taxed may benefit you.

The different types of retirement accounts

In Canada, there are Retirement Pension Plans that are funded by you, your employer, or both you and your employer, as well as retirement accounts that you can fund and manage completely on your own. Even if you have a pension plan through your employer, you can (and should) also contribute to another kind of retirement savings account.

Each type of account has its own set of “rules” that pertain to contribution limits, salary requirements, and taxes. Don’t worry, we will get into the nitty-gritty of each and every type of account so you can make the optimal choice to prepare for your retirement.

1. Registered Retirement Savings Plan (RRSP)

A Registered Retirement Savings Plan (RRSP) is the most popular vehicle for retirement savings in Canada. You or your spouse or common-law partner can contribute to your RRSP up to a certain limit. The annual contribution limit for an RRSP is 18% of a worker’s pay, up to $27,830 in 2021.

This money can then be invested into a variety of investment vehicles including mutual funds, ETFs, bonds, and annuities. It’s smart to diversify the investments in your RRSP to protect your portfolio from major losses caused by market fluctuations.

How it is taxed

An RRSP is a tax-deferred account. This means any income you earn in an RRSP is usually exempt from tax as long as the funds remain in the plan. Once you remove funds from an RRSP, taxes come into play.

As long as the funds aren’t locked in, you can withdraw money from your RRSP at any age, at which point you will generally have to pay income tax on the withdrawals. The exception is if you use the funds you withdraw to buy your first home or to pay for education.

The pro of a tax-deferred account is that you can invest pre-tax dollars, which increases the amount of money that has the potential to grow over time. Additionally, If you wait until you are retired to withdraw money from your RRSP,  your income tax rate may be dramatically reduced, and thus, the amount you pay in taxes on the money you withdraw will be far less than if you withdraw it earlier in your life.

2. Pooled Registered Pension Plan (PRPP)

A Pooled Registered Pension Plan (PRPP) is a relatively new type of retirement account available to Canadians working for an employer who chooses to participate in PRPP or for self-employed Canadians living in a province that has the supporting legislation in place. The pro of this type of account is that the assets within it are pooled, resulting in lower administration costs (read: fees).

The amount an individual can contribute to a PRPP is dependent on their income reported on previous tax returns. It is also dependent on how much that individual contributes to their RRSP, if they have one, because any contributions to a PRPP are counted toward the maximum amount they can contribute to their RRSP.

How it is taxed

Similar to RRSPs and other pension plans, PRPPs are tax-deferred accounts. This means PRPP contributions are made with pre-tax dollars and that the money grows tax-free. It is only once the money is withdrawn that it is taxed as income. Both individual and employer contributions to a PRPP are also deductible on an individual’s tax return.

3. Tax-Free Savings Account (TFSA)

A Tax-Free Savings Account (TFSA) is a type of savings account available to all Canadians over the age of 18. The contribution limit for a TFSA is $6000 in 2021. However, for any year where an individual cannot meet the contribution limit, the amount they did not deposit is rolled over to the following year, allowing them to make up the difference. Additionally, any withdrawals from a TFSA can be made up for with additional deposits.

Similar to an RRSP, the funds in a TFSA can be invested into various kinds of investments, including ETFs, mutual funds, stocks, and bonds. This allows anyone with a TFSA a great deal of flexibility as to where they choose to invest their funds, unlike many pension plans.

How it is taxed

A TFSA is funded with after-tax dollars. Generally, taxes are already taken out of the money you deposit into your bank when you receive your paycheque. You can then use this money to fund a TFSA. The great news is you won’t be taxed on that money or the growth again. This means when you make withdrawals from your TFSA in the future—which you can do at any time—you won’t have to pay taxes on anything you take out. Hence, the “Tax-Free” in “Tax-Free Savings Account.”

Which retirement account is right for me?

There are two main differences between Registered Retirement Savings Plans or Pooled Registered Pension Plans and Tax-Free Savings Accounts: how they are taxed and how much you can contribute.

Each of these accounts can be a great vehicle to save for retirement, and you don’t have to choose just one! You can hold both an RRSP and a TFSA at the same time and even have a pension plan too. Holding multiple accounts is a great way to maximize your savings not only for retirement but also for the purchase of a home or the cost of education.

Although there are tax advantages to retirement accounts, there is no type of account that enables you to avoid taxes. Beware of any schemes that claim you can access your RRSP withdrawals tax-free, or fund a TFSA with pre-tax dollars—they’re too good to be true.

How to make the most of your retirement account

Remember, you can only reap the value of a retirement account and its tax benefits if you actually use it. Funding a retirement account requires diligence when it comes to budgeting, saving, and investing. In fact, it is a wonderful lesson in all three of these basic principles of personal finance. Over time, as you continue to save for retirement and invest your funds, you will become well versed in these principles and develop money habits that will serve you well throughout your life.

Then, when the time comes to retire, you can feel confident that you can stick to a budget based on the full amount of the portfolio that your continued saving and investing has allotted you.