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What is RRSP & How it Works? Briefly explained

An RRSP is short for Registered Retirement Savings Plan. It's a well-known phrase for good reason: an RRSP is one of the best ways to save for your retirement and save on taxes at the same time.

Some people think that an RRSP is an investment or something that you purchase. It's neither. An RRSP is a government-approved account specially designed to help you save money for your retirement.

Tax deductible contributions

The amount you contribute to your RRSP can be claimed as a tax deduction. (There are some restrictions. More about those later.) For example, if you earn $40,000 annually, a $1,000 contribution can result in a tax refund of about $307. The higher your income, the higher your tax bracket and the larger the refund you’ll get for the same $1,000 contribution.

Tax-deferred compound growth

The money you earn on your contributions stays in your RRSP. You don't pay tax on it until you take it out of the plan. Even though you can withdraw RRSP money whenever you like, the idea is to keep your money in the plan until you retire. In most cases, withdrawals are treated as income, which means you'll pay tax on the money.

An RRSP is an ideal way to harness the power of compound growth.

Annual contribution limits

The government allows you to contribute up to 18% of your 2009 earned income, to a maximum of $22,000 for the 2010 tax year. (If your company has a pension or deferred profit sharing plan, your maximum contribution limit is likely lower.)

For example, if you earn $50,000, you are entitled to contribute about $9,000 to an RRSP for the next tax year. See more about .

Because anyone with eligible earned income earns "RRSP contribution room", you should file a tax return even if you owe no tax on your income. You can use this room in later years or immediately to put money in your RRSP. See more about RRSP carry-forward.

You can put part or all of your RRSP contributions into a plan in your spouse's or common-law partner's name. See more about spousal RRSPs.

Retirement income source

Like most good things, your RRSP will eventually come to end. In the year you turn 71, you need to convert or collapse your plan. Don't worry about getting a big tax bill. You have a number of retirement income options that allow your retirement savings to continue to grow in a tax-sheltered environment. Only payments to you from your plan are immediately taxed. So you can spread the tax on withdrawals over your retirement years.