02/26/2013 07:42 EST | Updated 04/27/2013 05:12 EDT

Is an RRSP the Right Choice for You?

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It is hard to get away from the ads for Registered Retirement Savings Plans (RRSPs) at this time of year. Every bank is encouraging you to make a contribution because it will mean a tax refund. They will even loan you money to make a contribution. But before you make an RRSP contribution, you should decide if it is the right choice for you.

We all want to retire at some point, so saving money for the future is a good idea. And RRSPs are one of the best tax shelters available to Canadians. But RRSPs do not offer a great deal of flexibility if you need to withdraw the money early, and you will be taxed on your RRSP withdrawals once you turn 71.

There is also a misconception about the tax refunds RRSPs can provide. Contributions are deducted from your taxable income, so they do result in tax savings. For example, if you earned $30,000 in 2012 and you contributed $2,500 to your RRSP, you will only pay tax on $27,500. But what does this mean as far as your refund? As a general rule of thumb, for every $1,000 you contribute to your RRSP, you will receive about $150 in federal tax savings, plus some provincial credit.

So depositing $5,000 into your RRSP will not result in a $5,000 tax refund. This is important to remember, especially if you are taking out a loan to pay for your RRSP contribution.

The amount of money you can deposit into an RRSP is determined by your income, up to a maximum amount. Your contribution room is included on your Notice of Assessment. You may not be able to use your limit right away but as you begin earning more income, the room will still be available.

RRSP withdrawals

If you withdraw money from your RRSP early, you immediately lose the tax benefits and your contribution room. The withdrawal is considered income and you will receive a T4RSP to report it on your tax return. Your financial institution is required to withhold a certain percentage for tax purposes, based on the amount of your withdrawal, but this amount may not be enough to cover your tax bill. It will depend on your income for the rest of the year.

There are two exceptions. The Home Buyers Plan allows first-time homebuyers to borrow up to $25,000 from their RRSP to buy a home without penalty. But you have to pay the amount back within 15 years or the withdrawal is considered income. And the Lifelong Learning Program allows you to borrow up to $20,000 from your RRSP to fund post-secondary education. The repayment has to happen within 10 years or, again, it is considered income and you will pay tax on it.

Tax Free Savings Account

RRSP used to be the only tax shelter available to save for retirement, but the Tax Free Savings Account (TFSA) was introduced in 2009 and offers more flexibility for saving. Unlike an RRSP, you can withdraw money from your TFSA without reporting it on your tax return. And you do not lose your contribution room, although you need to wait until the next calendar to re-deposit funds.

Your TFSA contribution room is not tied to your income. For 2013, the annual contribution limit is $5,500, regardless of how much you make. And a TFSA does not need to be just a regular savings account: there are options which offer greater returns but, like with most things in life, bigger rewards mean higher risk. Make sure you understand what you are investing in before you make a deposit.

So if you need access to your money or you are saving for shorter-term goals, the TFSA may be a better option than an RRSP. But there are penalties for over contributing so make sure you understand the rules when you open your account.

Starting early

Thinking about retirement when it is still 30 or 40 years in the future may be tough, but saving early is the best strategy. Treat your retirement savings like another bill, so you get in the habit of depositing. It may be easier for your budget to make a monthly contribution rather than trying to come up with a large sum as the deadline looms.

And before you open an RRSP or TFSA, make sure you understand the risks involved and where your money is being invested. If it seems too good to be true it probably is, so pay attention to your money. You may not withdraw it until you retire but you want to ensure it is there when you decide to stop working.

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