Between going to work, buying groceries, keeping your car running, getting the kids to practice, and ensuring you have enough money to make ends meet at the end of the month, it’s not a total shock that millions of Canadians forego retirement planning. After all, delayed gratification can be a tough concept for anyone to grasp.
Retirement savings, however, are one of those things that are best started early, even if you only have a small amount of capital to get the ball rolling. If only there was a type of account that helped facilitate retirement savings so as to maximize gains and minimize long term losses... Of course, you know there is. Our American neighbours have the 401(k), which has become eponymous with retirement savings accounts. We Canadians have a similar account structure and, in many ways, far more options. Read on to learn a bit more about the equivalent of the 401(k) here in Canada.
What is the 401(k)?
Despite its ubiquitous nature, a 401(k) is a purely American account. It is a retirement account offered by an employer who may, as part of a total compensation package, contribute or match the employee's contributions to the account. It’s named not for a fancy investment of any kind but rather, the part of the Internal Revenue Service tax code that governs tax-free retirement savings.
The accounts are employer-sponsored mainly because the deposits are automatically deducted from the employee’s paycheque. These deductions are taken before tax, which is a huge benefit to employees. When the employee retires, they are able to withdraw cash from the account, paying taxes on those withdrawals.
So, Canada has one of these?
Kind of. Canada has what are called Registered Retirement Savings Plans or RRSPs. These plans are still primarily managed and offered by employers but there are private options for accounts as well. The funds are contributed tax-free up to a certain limit each year, and that cap can be rolled over to subsequent years if you don’t use all of it. Your RRSP contribution limit for 2021 is 18% of earned income you reported on your tax return in the previous year, up to a maximum of $27,830. You are not permitted to exceed that amount so if you’ve got extra capital you want to hold onto for retirement, be sure to open other accounts and investment vehicles as well.
RRSP accounts aren’t just savings accounts where funds are stored. When you make a deposit, you’ll elect how your funds are to be invested. Many RRSPs offer target investment plans, meaning if you’re planning to retire in 2035, the mix of stocks, bonds, and Exchange Traded Funds (ETFs) will align with how much risk you can tolerate before retiring. If you’re retiring in the next five years, you don’t want a highly volatile portfolio of stocks that vacillate wildly in value.
This creates one of the fantastic benefits of RRSPs: in many ways, you can set it and forget it. If your employer offers an RRSP, you can simply elect to deduct a portion of your paycheque each period to go towards your account. Ensure that the account is set up to your liking and let it roll. It’s a good idea to check in every now and again to ensure your goals are still reflected in the account, but you truly can continually pump money into it and let it grow, especially in your younger years.
Alternatively, you can take a firmer hand and dictate exactly how that money is invested by controlling the mix of stocks, bonds, ETFs, and other assets. It’s completely up to how comfortable you are managing investment accounts.
Is this free?
Typically, no. Banks and financial institutions that offer RRSP accounts will generally take a small cut of your account or transactions. These will always be clearly marked and you’ll often have a say over how much you pay; you can do this by ensuring you only purchase funds that have low management costs.
What are some similarities between 401(k)s and RRSPs?
Both are retirement accounts
It may seem relatively obvious but here it is nonetheless. Both accounts are designed for you to save for your retirement. Your ultimate goal should be to send this money into the account and not touch it again until you start withdrawing from it during retirement.
Both accounts are tax-advantaged
Both 401(k)s and RRSP deductions are taken before tax is paid. This means that when you elect to contribute 5% of your paycheque, you’re getting 5% of the gross pay, not 5% of the stuff you end up seeing on your pay stub.
Both accounts have annual contribution limits
You can only give so much each year to 401(k)s or RRSPs. If you have more money you’d like to save for retirement, you need to set up a different type of account and invest appropriately, likely without tax-advantaged status.
What about differences?
401(k)s are less portable
Americans can only take advantage of the benefits of 401(k)s via an employer. If they want to save for retirement but do not have a 401(k) as an option or are not employed, they’ll need to set up a different type of account.
RRSPs don’t have a catchup
When Americans turn 50, they get $5,000 of extra cap space to contribute to their 401(k)s. Canadians do not. The limits remain the same so you’re stuck contributing what you’ve got. This is offset, however, by some of the other retirement options open to Canadians, like the Canadian Pension Plan.
401(k)s have nasty early withdrawal fees
Not only do Americans pay tax on any funds they withdraw from their 401(k)s, but if they want to withdraw that amount before age 59 ½, they have to pay a 10% fee on top of the taxes. This can be quite substantial and makes 401(k)s one of the last places you’d want to pull from in an emergency. RRSPs do not have early withdrawal fees, but do require taxes to be paid.
RRSP contribution limits can be carried forward
Potentially the most impactful part here: RRSP limits can be moved to subsequent years. In 2021, the cap was set at $27,830. Let’s say you only contribute $20,000 this year. You can slide that $7,830 to subsequent years, effectively increasing your cap in 2022 to $35,660.
Are RRSPs insured at all?
Like many of your other accounts, RRSPs are insured against loss due to bank insolvency. It’s important to note that they are not insured against losses due to market changes. What this means is that you can still lose money if stocks you’ve selected go down in price. You will be made whole, however, if you lose money as a result of the financial institution that manages your RRSP going out of business.
Are there other types of retirement accounts in Canada?
Sure are! There are a whole host of different retirement options for Canadian citizens. One type is called a Registered Retirement Income Fund (RRFI), which gives you a set payout each month in retirement. These aren’t necessarily as powerful as RRSPs because you’re locked into the amount you’ll receive at the front end, taking growth out of the picture.
Another common account type that is used for retirement is a Tax-Free Savings Account or a TFSA. The Canadian government created these accounts to push people to save more. Money contributed to these accounts after taxes and is not taxable when withdrawn. This can be a powerful tool for many Canadians.
Finally, ordinary investment accounts are a key vehicle that Canadians can use to save for retirement or really anything else. These are not tax-advantaged in any way, though. Moreover, you’ll likely be taxed on the capital gains earned from investing in these accounts. Still, they are an important part of a well-rounded investment strategy.
Our Southern neighbours have their style of retirement accounts and we have ours. 401(k)s are primarily employer-based, while RRSPs can be opened and managed through an employer or privately. Both accounts feature caps on how much tax-free dough you can stash away in them each year, though in RRSPs you can carry that unused amount forward. There are some other key differences and similarities but the key takeaway is clear: governments want their citizens to save for retirement and provide ways for them to do so. Employers are also able to use 401(k) or RRSP matching as a great added benefit of employment to attract high-quality workers. If you’re not already contributing to an RRSP (or a 401(K) if you’re in America) get on it right away; the earlier you start the better off your account will be in the long haul.
