Canadian RRSP Vs. U.S. 401(k) Retirement Account Comparison

by Mike Holman

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I had a request recently from a blogger friend of mine – Paid Twice, who thought it would be a good idea to do a post on the common U.S. and Canadian investment accounts and try to find which ones are comparable. This post deals with the Canadian RRSP and the U.S. 401(k) plan – other accounts will be covered in future posts. I’m only going to do the more common accounts, since the more obscure types probably aren’t known very well on either side of the border.

Please note that this is just a general comparison – it’s not intended to be reference material for any of the accounts listed.

A big thanks to Madison from My Dollar Plan for helping out with this series.

canada_flag.gif mini-americanflag.gif

Canadian retirement account

RRSP (Registered Retirement Savings Plan )

US equivalent

401(k)

Similarities

  • Money in these accounts are considered pre-tax which means that you are taxed at marginal rates upon withdrawal. Basically you add any withdrawals to your income in the year you do a withdrawal.
  • Grow tax free inside the account. No taxation for capital gains, dividends, interest etc.
  • Both types have annual contribution limits.

Differences

  • 401(k) is setup with your employer plan whereas an RRSP can be setup with any financial institution.
  • 401(k) contributions can only be made through payroll deductions whereas RRSP contributions can be made through payroll deductions (commonly through employer-sponsored group RRSP plans) as well as cash (after tax) contributions which then generate a tax rebate.
  • 401(k) has a 10% penalty (with some exceptions) for withdrawal before the age of 59.5 (why the .5?) – the RRSP has no withdrawal penalties.  There are some exceptions where you can withdraw 401(k) money early.
  • Contribution limit for an RRSP is set as a percentage of the previous years income (18% or a maximum of $20,000). the 401(k) annual limit is $15,500 for everyone regardless of how much money you earn. Americans older than 50 can contribute an extra $5,000 per year.
  • In the RRSP – unused contribution limits can be carried forward indefinitely. 401(k) contribution amounts have to be used each year or they are lost.

Conclusion

These accounts are very similar in that the contributions are made pre-tax, no taxes are paid inside the account and withdrawals are taxed at the marginal income rates. The US 401(k) has more restrictions in terms of setting up an account as well as withdrawals. I personally like to have less restrictions on retirement accounts but in some cases the restrictions will prevent people from taking the money out for silly reasons.

Here is more info on RRSP contribution limits.

 

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{ 24 comments… read them below or add one }

1 Hazy

RRSPs seem to be more flexible overall.
But I do like the 401k contribution limit.
This could reduce the tax load during the working years,depending on how much earned income you have.
The withdrawal restrictions may offset these saving abit in the long run though.

2 Four Pillars

Hazy – if you are invested in the 401k for long enough (and you get old enough) then there are no restrictions on withdrawals. It’s the short run where the withdrawal penalties will cause a problem.

Mike

3 telly

Great post!

One thing I would add is that there are ways to access a 401k early without penalty. It’s quite easy if you’re between 55 and 59.5 but even if you’re younger than 55 you can access your 401k using a Section 72(t) distribution. In a 72(t) withdrawal, the distributions must be “substantially equal” payments based upon your life expectancy. Once the distributions begin, they must continue for a period of five years or until you reach age 59, which ever is longest.

While I agree that being able to carry over contribution limits is a HUGE advantage for Canadians, I find that a LOT more Americans I know “max out” their 401k contributions each year than do the Canadians I know. I think the carry forward attribute of RRSPs has a lot to do with that. When it’s “use it or lose it”, you tend to be better about using it. :)

Often times in Canada we get caught up in the notion that, in our early years our incomes are quite low so we can put off contributing until we’re earning more. Unfortunately, we end up missing a number of years of compounding that would likely outweigh the better return in later years due to being in higher tax bracket.

One of my former co-workers, a young 25 year old, maxed out his 401k every year for the last 3-4 years. He was only earning $30-40k so as a percentage, $15,500 is huge! But again, the “use it or lose it” attitude made him take advantage of it, despite the student loans he still has. At this rate, he may be able to stop contributing to his 401k when he’s 35!

Sorry for the diatribe!

4 Hazy

You are correct.
I guess I used the wrong expression there.
I should have said “overall” instead of “in the long run”.

No mention of the RRSP limits?

5 Mr. Cheap

Very interesting post, I’ll look forward to future posts in the series! My understanding is that a 403(b) is basically the same as a 401(k) – except they’re for non-profits.

I do like the withdrawal flexibility of the RRSP. My income has fluctuated MASSIVELY over the years. I never took advantage of it, but it would have been great to have socked away cash in the boom years in an RRSP and withdrawn it in the lean years (It would have spread out my taxation a bit).

6 Canadian Capitalist

telly has a good point with the “use it or lose it” restriction of 401(k) accounts. Still, a carry forward is useful for disciplined investors as it can be used to take advantage of differing brackets (esp. people with variable income, new moms etc.). I didn’t know much about 401(k)s, so thanks for the post.

7 Four Pillars

Telly – thanks for the info. I didn’t mention the other ways to get $ out of the 401k because I didn’t want to have too many details.

I agree that the “use it or lose it” aspect of 401k is a good motivator. In theory the Canadian system is better but in reality, more people might be better with the more restrictive American system.

Hazy – I left out the contribution limits because I didn’t want this to be a “complete” post on the rrsp or 401k – just a comparison. That might be an idea for a separate post however.

Mike

8 Mrs. Micah

I think the 59.5 rule allows you to get everything set up for your 60th birthday. If you wanted to take retirement at or right around age 60, it would really suck to get deductions set up a few weeks before your birthday and pay the penalties. I’m guessing the 1/2 year is to keep the system from penalizing those who fulfill the spirit of the rule.

9 Quietrose

Great post, Mike! Very informative!

One thing I can say about the 403(b) plan that Mr. Cheap commented on is that there is usually no contribution by the employer, since it is typically for non-profit organizations. I have a 403 (b) plan from a previous employer and they did not contribute or match any of my savings in the plan. I wish they did!

10 The Reverend

Hazy,

RRSP contribution limits are 18% of previous years income, up to a limit. I believe the 2008 limit is 20,000 (equivalent 2007 income of $111,111).

I believe another feature of RRSP not mentioned (unless I missed it), is that you can make contributions and start the tax-free growth, but rollforward the income tax deduction. This is not utilized very much in my experience.

11 Four Pillars

Hazy & Telly – I made changes to the post to include your points.

12 Dividend Growth Investor

The beauty of 401K plans is when your employer matches up your contributions up to a certain level. For example if I make 10,000/year and my employer matches 100% of my contributions on the first 3% and I contribute 3%, then for investing 300 dollars/year I get anotehr 300 dollars.

13 Hazy

In Canada,my employer offers me a 3% match as well.
The bad news is that this reduces my RRSP contribution limit by 3%,thus no tax break on that money.
Also,that money is locked in to my employer’s plan with its limited investment options.
Right now my money in stuck in some seg. funds over at Sun Life.
Still a good deal perhaps,but not as good as it sounds.

What are the investment options in a 401k?

14 telly

Hazy,

Apparently the investment options in 401k’s vary considerably (as do group RRSPs). From what I’ve heard, my plan seems to be pretty good. One half of my 401k can be transferred to a Schwab online brokerage account (where I’ve been buying mostly ETFs), the other 1/2 remains in the standard employer 401k where I can choose between 13 funds (3 of which are Vanguard index funds) with a MER range of 0.07-1.57.

Like yours, my husband’s Group RRSP is with Sunlife and the MER’s are ~2-3%. However, US mutual funds have much lower MER than Canadian funds in general.

15 Gates VP

Hey guys, I now have both. Though my expertise is far from complete, I do have a couple of extra points.

- 401k matching can be subject to a “vesting period”. People I’ve spoken with say this is uncommon but it happens. For example, I’m getting a 25% match on up to 6% of my income invested in the 401k. But I only “vest” 25% of the match each year. So it’s looks like I’m saving 7.5%, but if I leave the company I have to “pay back” the non-vested portion of the 401k :(

- The “use or lose it aspect” may drive some to max out their 401k, however, there’s also the 401k limbo that happens when you change jobs. It’s not uncommon to hear about people who treat this as “found money” and start spending the money without recognizing the tax implications.

- Also, the 401k now comes in two varieties, the “regular” and the “Roth”. Both grow tax-free, but the “Roth” is taxed on the way in (not on the way out).

- 401k plans can vary quite dramatically in terms of quality, as they’re all managed. You can end up bleeding points b/c you don’t have the right available choices.

- 401k doesn’t have the simplicity, transparency and investing flexibiliy that you find in an RRSP. RRSPs in Canada are really treated like a separate “bin”. If I open an on-line trading account in Canada, say with my bank (BMO Investorline), I get two “bins” that I can manage in parallel.
My 401k is nothing like this. I get a chance every three months to modify my mix of funds, but that’s about it. Based on the comments above this sounds similar to the group RRSP plans.

Overall, I much prefer the RRSP program if only for its sheer simplicity. The 401k, was originally meant as a special piece of the tax code to appeal to specific companies who didn’t want to offer the traditional company pensions. The RRSP was designed from scratch to be a complete retirement vehicle. It’s both easier to implement and easier to understand.

16 Telly

Gates: Welcome to the world of both RRSPs AND 401ks!

Like your point about 401k’s, many group RRSP’s in Canada also require a vesting period. From what I understand, this is common in both the US and in Canada. Not sure if it’s a good or a bad thing, but vesting certainly encourages people to stay put a little longer.

17 Gates VP

but vesting certainly encourages people to stay put a little longer

Vesting clauses leave a really bad taste in my mouth because they seem like really underhanded ways to do just that. It’s like they’re trying to take advantage of the average person’s inability to handle sunk costs and to “cut their losses”.

I recently heard the term “Golden Handcuffs” for vested stock options and I couldn’t imagine anything more appropriate :)

BTW, Telly, do you have any way I could message you? I just moved to the US with 5 other people, so any knowledge about the whole US / Canada tax law is really useful. I was hoping to pick your brain :)

18 telly

I’ve heard the term “Golden Handcuffs” as well. It’s not far from the truth. It’s one thing when most companies aren’t offering a pension anymore but when the one thing you do have (which you have to fund as well), could be lost just because you didn’t spend x number of years at your company – you really are handcuffed.

This is an especially difficult situation for Americans in the tech industry, where people are laid off regularly and very few people end up staying with any particular company for more than a few years at a time. No pension, no vesting in 401k’s, with the only real option being Roth IRAs, with a $4-5k / yr contribution limit. you really are going it alone these days…

Gates, I left a comment at your blog so you should have access to my email address. Ask away, I’ll do what I can!

19 My Dollar Plan

I love the way the series turned out. Great job Mike!

20 TexaCan

Another great post. (I started with the TFSA vs RothIRA article.) Great comments too! I just want to take a different take on why the US 401k is structured as it is. I think it is more to discourage investment than to keep people from withdrawing for “silly reasons”. I would posit that for the last 30 years, the US has become more protecitve of Employers, with lesser regard for Employees. (a la “Reaganomics”) In the US, employee benefits, including retirement savings (401k) and affordable medical insurance are tied to the employer. These are “silver hand-cuffs”, if you will. So long as you are employed and stay with the same employer, things are straight forward. However, when you change employers, or lose your job, you must change (or lose) medical insurance plans and you should “roll-over” your retirement accounts to a new retirment account (Non-Roth IRA, or a new employer’s 401k). Of course, roll-overs may be subject to additional fees. If you opt to keep the 401k account with the original employer, you are not allowed to make further contributions or perform any investment actions such as investment re-distribution. The bottom line is that the 401k is designed to make changing employers less “convenient” and early withdrawls are hit with stiff penalities. The main attraction of the 401k plan is that many employers will supplement contributions to the account by matching a portion of employee contributions or contribute a minimum amount. As pointed out above, this is a great benefit. But, it is not mandatory and contribution plans are not consistent between employers. As well, employee participation is not manditory as was the case with company pensions. In short, the employee (a.k.a. investor!) -oriented Canadian RRSP is a much simpler account. Coupled with employer matching, the RRSP is a superior account. Now that the “Roth-like” TFSA has been created, I am one expat who may yet move back!

21 Roar

I always thought a 401k was closer match to an employer defined contribution pension plan and the IRA as a closer match to the RRSP?
And a ROTH IRA would be similar to a TFSA?

I have a defined contribution PP, 5% me, 6% employer vested to min. age 50 and/or when you retire.
I also have a Group RRSP at work with personal contributions only.
I also have a personal RRSP set up with the banks, again with personal contributions only.

22 Canadian Investor

Very interesting post and comments which do help to understand the comparison a bit better.

Couple of things to note on the RRSP. While there is not a “penalty” on early redemptions for an RRSP there is withholding tax on the amount redeemed. 10 % for $0 – $5000, 20% for $5001 – $15 000, and 30% for >$15 000. In addition, replacing any redeemed portions reduces your carry forward room on the contribution side. So not quite penalty-free.

Perks missed. You are able to continue to contribute to an RRSP as long as you have employment income claimed up to 70 years of age. Once you turn 71 the RRSP must be closed down by the end of the calendar year — moved into an annuity, RRIF (another tax deferred account), or a lump sum removal (really not advised because there are major tax implications). So there is an additional 11.5 years with an RRSP were there are no mandatory withdrawals from the plan.

There is also the ability to borrow against your RRSP for a first time home purchase in Canada and for a return to school (Life Long Learning) at some point later on in life. This money must be repaid to the RRSP but the money is not subject to with holding tax so it is a great incentive.

23 Trevor

Another bonus to Canadian RRSP’s: our conservative government has relatively recently added two early-withdrawl programs: the First-Time Homebuyers Plan (HBP) and the Life-Long Learning Plan (LLP). Essentially you have access to 25K from your RRSP for a down payment on a house (HBP) and 20K if you, or your spouse is attending post-secondary education (LLP).

This is a HUGE benefit for me. I recently started working and have an employer match contribution of 10% (20% total contribution – 10% from me and 10% from my employer). Contributing the max to my RRSP really decimates my paycheck and non-RRSP savings are limited. However, if I do not contribute the max I’m essentially giving up free money from my employer.

Since my spouse is attending university and we plan to buy a house within 5 years, I have access to 45K from my RRSPS without penalty, tax free* (I do however, have to pay them back within 10 years or else I must declare them as income). In some respects, my employer is paying for half of my spouses university and half of our down payment!

I do realize that this is not wise in terms of long-term retirement plans, but I’m young (27) and in reality, the hardest time in someone’s life is not when they retire, it’s when they’re just starting a family and income is relatively low.

24 CH

For 2012 I paid about 17K for my 40k plan and now CRA is considering 17K taxable income and they calculated 6 K tax on 17K in reassessment. What is the process to differ this savings?

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