It is RRSP season and that means….time to learn about RRSPs!
Most people already have some difficulty understanding them and Muslims, in particular, may even avoid them because they are not sure if they are halal or how to use it in a halal manner. In this article, I will give a brief overview of how an RRSP works, the main benefits and limitations, what makes an RRSP halal, why the RRSP deadline matters and finally, some take-home tips.
How it works
RRSPs are designed to encourage individuals to save for their retirement. They are known as tax-sheltered accounts, meaning any investment income (i.e. capital gains and dividends) is not taxed within the account. In addition to being tax-sheltered, RRSP are tax-deductible, meaning the money you contribute into your RRSP gets deducted from your taxable income. This lowers your tax bill and often provides individuals with a tax refund based on the year they contributed towards. At the age of 71 (or before if one chooses), the RRSP will convert into a RIF that makes monthly, quarterly or annual payouts, acting as retirement income.
Tax-deductable: The main benefit of an RRSP is that you can defer paying taxes on some income today and pay it later in retirement. More money upfront today means more money that can be invested over a long period of time instead of it going to the government.
Tax-sheltered: Any investment income earned within an RRSP is also not taxed (as long as funds are not withdrawn out of the account), adding more to the compounding effect of returns over time.
It forces you to save for retirement: In light of the two benefits mentioned above, individuals have a high incentive to put money towards their retirement and this is a benefit on its own as it encourages a good financial habit.
Limitations to be aware of
- Not truly tax-free: While contributing to an RRSP provides a nice tax-break, this does not come for free! You will eventually be taxed when you withdraw money either through a RIF when you retire or through withholding tax if you withdraw early (before retirement). Generally, it is not a good idea to contribute to an RRSP if one is planning to withdraw the funds in the short-term. However, there are exceptions where one can withdraw from their RRSP early tax-free under the Home Buyer’s Plan or Lifelong Learning Plan if one is buying their first home or going back to school. One must be eligible and certain repayment conditions need to be met. You can learn more about these programs here and here.
- Contribution limits: The other thing to keep in mind is that RRSPs have contribution limits. The good news is limits are quite high for most: 18% of one’s pre-tax earned income for 2020 or $27,230, whichever is less.
When is the deadline and why does it matter?
Individuals have until March 1st, 2021 to contribute to our RRSPs and lower taxes on income for the year 2020. This is important because generally by this time (or sometime in February) your employer will have your T4 ready or if you are self-employed, you should have a good idea of how much money you made last year. This way you can calculate more precisely how much money to contribute to your RRSP for tax savings to really matter. For example, $4654 could be the exact amount Khadijah needs to get below a certain tax bracket and get taxed at a lower rate.
Any amount contributed after (and before next year’s deadline) that will count towards 2021 income which you may not be able to know precisely so early in the year.
What makes an RRSP halal?
It’s a common misconception that RRSPs are not halal or at best a grey area because it is common to see RRSP invested in mixed mutual funds or even offered as high-interest savings options at your local bank. However, RRSPs in and of themselves are just a neutral account that offers halal tax benefits.
It helps to think of an RRSP (or any account) – as a cup. If you fill it with wine, it becomes impermissible to consume, if you fill it with ginger tea, you’re good to go. Likewise, with an RRSP, if you put bonds, GICs or stocks that are not shariah-compliant, earnings from those are not permissible to consume and need to be purified. On the other hand, holding a halal Exchange-Traded Funds (ETFs) (eg. Wahed’s US equity ETF $HLAL), Shariah-compliant stocks, Sukuk (eg. Manzil’s halal mortgage fund) or even just holding cash that pays no interest is perfectly fine.
Note: Shariah-compliant stocks may need a manual purification calculation for any impermissible earnings. Halal ETFs usually provide a purification ratio to apply to dividends.
For Muslims wanting to make sure their RRSP only contains halal investments, the two main choices are:
Opening a self-directed RRSP through a discount broker and choose your own mix of shariah-compliant stocks and halal ETFs.
Open an RRSP with a halal provider like Manzil, who offer their own halal investment package and do the investing for you.
Manzil’s offering is quite unique as they give you exposure to stable income through their halal mortgage fund (nothing like it anywhere in Canada) as well as halal US stock exposure through the Wahed ETF. A great choice for diversifying your wealth and putting your investments on autopilot.
I hope you found this article beneficial. Here are some bonus tips and key takeaways:
RRSP are inherently halal, what truly makes it halal in the end is what YOU decide to put in it
The tax breaks RRSPs provide allow for more money to be invested today for longer and allow investment income to grow and be reinvested tax-free
Remember that withdrawals are taxed, but there are exceptions when withdrawing for your first home or going back to school (certain conditions apply)
An RRSP is most efficiently used if contributing when one is in a higher income tax bracket and withdrawing when in a lower income tax bracket (usually this retirement age for most)
Consider re-investing the RRSP tax refund back into your RRSP to maximize your investment returns over time
Using a spousal RRSP, one can even deduct from the taxable of the contributing spouse, while benefiting from the lower tax rate of the spouse the RRSP is meant for (this works well if one the contributing spouse has a higher income)
Don’t forget to contribute before March 1st!