RRSPs and LIRAs are two of the most popular retirement savings vehicles in Canada. Both are meant to provide you with an income in your retirement years.
However, there are several important differences between these two investment vehicles. This article discusses RRSPs and LIRAs and their differences. So if you are someone who’s confused about the two and you’re looking to find out what sets these apart then this article will help. Let’s begin!
What is a RRSP?
RRSP stands for Registered Retirement Savings Plan. A RRSP is a savings plan, registered with the Canadian federal government that you can contribute to for your retirement. It offers certain tax benefits that make it attractive as a retirement savings plan vs. if you were to save money in a regular savings account at your bank.
Funds that you contribute to a RRSP are considered “tax-sheltered” because they’re exempt from being taxed in the year you make the contribution. You pay tax on the funds only when you start making withdrawals in the future (at retirement).
The RRSP was introduced back in 1957 in Canada as a part of Canada’s Income Tax Act. Like the TFSA, the RRSP also offers different types of investment vehicles such as mutual funds and GICs.
In general, the Canada Revenue Agency calculates your RRSP deduction limit as 18% of the earned income amount that you reported on your previous year’s tax return. Subtract from that any contributions to a pension plan at work.
What is a LIRA?
LIRA stands for Locked-in Retirement Account. It is a Canadian pension savings account that holds funds which are not allowed to be withdrawn until retirement, normally age 55 minimum. This is also a “tax-sheltered” account.
If your employer offers a pension plan, you’ll need to determine what to do with it if you quit your employment. Transferring the pension plan to a LIRA can be one of your choices. The LIRA allows you to personally manage the growth of your pension from your former employer.
If your pension funds are contained within a LIRA, your funds will be “locked-in”, which means you won’t be able to access them until you retire. Plus, there is a maximum limit to how much you can withdraw. However, they can be transferred to a different retirement fund or used to purchase a life annuity.
However, there are a couple of very specific circumstances where you may be allowed to withdraw from a LIRA before retirement such as:
- Reduced life expectancy.
- You find yourself dealing with unemployment or a low income situation.
- Wanting to exercise the one-time ability to unlock 50% of your LIRA and transfer it into a Life Income Fund (LIF) or Life Income Type Benefit (LITB) if you’re age 50 or older.
- If you become a non-resident of Canada.
Unlike an RRSP, you won’t be able to use it for funding your education or a house purchase (The Home Buyers Plan). Your funds are “locked-in”, but it gives you peace of mind that you’ll know your money will be safe when it comes time to retire and transform your LIRA funds into retirement income.
Tax-wise, funds you have in a LIRA won’t be taxed until you withdraw the funds when you purchase a life annuity or transfer them to a retirement income product, a LIF, life income fund. Plus 50% can be unlocked by transfer to an RRSP or RRIF.
You don’t contribute money each year into a LIRA like you would an RRSP, instead the funds come from your pension plan when you leave an employer and choose to turn those pension funds into a LIRA.
Benefits and Disadvantages of RRSPs
Benefits and advantages of a RRSP:
- Contributions are tax-deductible: The money you put into your RRSP is deductible from your income, and as a result, it reduces your taxable income. So if you make $50,000 a year and put $5,000 in it, then your taxable income will be reduced from $50,000 down to $45,000.
- Tax-deferred growth: This is critical. You deposit money to an RRSP to save income tax at a high tax rate. (Remember, Canada’s tax system works on a gradient: higher income equates higher tax rate. Have a look at your “marginal tax rate”. Part 2 of this story is: you withdraw in retirement when you are in a lower tax bracket, i.e. lower tax rate. By putting your money in an RRSP account, your money grows tax sheltered. You don’t pay tax on gains. Returns are exempt from any capital gains tax, dividend tax, or income tax.
- Good for retirement planning: One big advantage of RRSP is that it allows you to plan for your retirement. In many cases, people end up making a lot less in the years when they retire. If you put money into an RRSP early on, you will have funds to live off once you retire.
- Protected from creditors: Funds in your RRSP are protected and covered under Canada’s Bankruptcy and Insolvency Act once you declare bankruptcy. So, a RRSP provides asset protection from creditors and legal proceedings.
- You can borrow money from your RRSP for buying a home or paying for education: Another great benefit of having an RRSP is that you can borrow money from it for buying a house or paying for your children’s education through the Home Buyers’ Plan (HBP) and the Lifelong Learning Plan (LLP). These plans allow Canadians to pull funds out of their RRSPs interest and tax-free in order to buy a home or get educated. Keep in mind, it does need to be paid back (over 15 years for the HBP and 10 years for the LLP).
Disadvantages of an RRSP:
- You have to pay a penalty for withdrawing early: Unlike a TFSA, when you withdraw any money from an RRSP , the government charges you a “withholding tax”. This tax amount depends on how much you take out and where you live, but in general will be between 10%-30% of the amount withdrawn. Withdrawing $5,000 has a withholding tax rate of 10%, withdrawing between $5,001 and $15,000 has a withholding tax rate of 20%, and withdrawing more than $15,000 has a withholding tax rate as high as 30%. These become tax credits for next years tax filing. Another thing to note about withdrawing early is that you lose your contribution room once you take money out, you don’t gain that contribution room back. However, if you have no income in any year, a good strategy may be to withdraw a small amount, under $14,000. You won’t be taxed at that amount.
- Contribution limits depend on your income: RRSPs are only beneficial if you make enough money. The more you earn, the higher your contribution limit is.
- You have to close your account by the age of 71: Another downside of RRSP is that you have to close your account by the age of 71. It must be used for retirement purposes by converting to a RRIF. After that, your only tax shelthered savings account is a TFSA.
- Low liquidity: Your RRSP is meant to be a long-term savings vehicle that you don’t touch until your retirement, this can be a disadvantage if you need to take the money out sooner. Why? because you’ll add the withdrawal to your income. You could be in a high tax bracket.
- Contributions are limited: There is a limit on the amount that you can contribute to your RRSP, which is typically 18% of earned income you reported on your tax return in the previous year.
Benefits and Disadvantages of a LIRA
The following are the benefits of a LIRA:
- Can be converted to LIF: A LIRA can be converted to a locked-in life income fund (LIF) so that money saved in it can be used for retirement. It can be helpful when you retire in an unpredictable financial situation. When you convert your LIRA to a LIF, you have the option to “unlock” 50%. So you end up with 1/2 in the LIF and 1/2 in a RRIF. All fully taxable on withdrawal.
- You can purchase a life annuity: In some cases, LIRAs can be used to purchase a life annuity which is an insurance product that provides a fixed or variable income for the rest of your life.
- Inheritance: If you die prior to reaching retirement age, the funds in your LIRA will transfer to your spouse or common-law partner. In this case, the funds pass to a non locked-in account, an RRSP or a RRIF. There is no tax on this “spousal rollover”, but all funds are taxable for the inheritor when funds are withdrawn.
- Holds your pension money: A LIRA holds your pension money after it is transferred to you from your previous employer’s pension plan, allowing you to become the steward of your own pension plan.
The following are the disadvantages of a LIRA:
- Can not make withdrawals before age 55: You cannot make withdrawals from a LIRA before you’re 55 years old, hence it being “locked-in”.
- Less flexible than a RRSP: a LIRA is less flexible than a regular RRSP. Once you have set up a LIRA, you cannot make additional contributions to it. The funds come directly from your pension.
- You must convert your LIRA before age 72: By the end of the year you turn 71, your LIRA must be converted to either a life annuity or to a Life Income Fund (LIF) or LRIF (Locked-in Restricted Life Income Fund). There is a maximum withdrawal amount. Remember, with both the RRIF & the LIF, there are minimum withdrawal rates. You MUST withdraw some money. The government wants their taxes!
Key Differences Between LIRAs and RRSPs
- LIRAs hold pension money. On the other hand, a RRSP is a retirement savings plan that holds funds that you personally contribute.
- A RRSP offers more flexibility than a LIRA because it allows withdrawals at any time. Early withdrawals do have the “withholding tax” penalty, but it is still possible to do so in case of emergency. whereas, a LIRA is normally not available til age 55.
- You can borrow money from your RRSP early for certain things such as education or a house. This is not possible with funds in a LIRA.
Both a LIRA and an RRSP help you save money for your retirement, but they both have different benefits and disadvantages. Before opening a RRSP or LIRA, it is very important to evaluate your financial situation and choose the one that will meet all of your needs. Consult with a Certified Financial Planner at Pension Solutions Canada to determine the best retirement plan for you. Many factors affect your decision, so it is important to know all your options.
At Pension Solutions Canada, we specialize in assisting people in preparing for retirement. Allow us to evaluate and review your retirement income sources and assist you with retirement planning. Call us at 1-888-554-6661, or click here to book a virtual Zoom meeting.