401k vs RRSP: A Side by Side Comparison

Many American-Canadian dual citizens have employer-sponsored retirement plans from multiple employers. Some of these plans are 401(k) plans, while others might be RRSP plans.

In this article, we’ll explore each of these retirement savings plans in depth. That way, you can make the most sense of them as you take charge of your retirement planning and your financial future.

Let’s start by going over each plan in some detail.

What is a 401(k)?

A 401(k) plan is an employer-sponsored retirement plan available to U.S. employers for their employees based in the United States. In contrast to a standard pension plan, also known as a defined benefit plan, a 401k is known as a defined contribution plan.

A 401k allows for the employee and the employer to make tax-deferred contributions to a retirement savings account.By deferring taxable income, an employee can lower their tax rates in their high income years.

Eventually in future years, the taxpayer will have to withdraw the money and pay income taxes. But the hope is that the taxable income will be at lower tax rates in retirement.

Contribution limits

401k plans are subject to an annual contribution limit. This applies to both:

• Employee contributions ($20,500 in 2022)
• Overall contributions, which include employee AND employer contributions ($61,000 in 2022).

Employees who are at least 50 years of age are allowed a catchup contribution, in addition to the annual limit. In 2022, the catchup contribution is $6,500.

Employers can provide a matching contribution (matching employee contributions by a stated amount), or they may choose not to. Most employees are encouraged to participate in their retirement plans to at least receive the employer match, which is free money.

Withdrawal rules

There are two types of 401k plans:

• Traditional 401k: The employee’s contributions are tax-deferred. This means that the employee is not taxed on earned income that goes into their 401k. However, when the employee withdraws the money, he or she is taxed in the year of withdrawal.
• Roth 401k: The employee’s contributions are taxed as ordinary income in the year of contribution. However, earnings in this account accumulate on a tax-deferred basis. Qualified withdrawals can be made tax-free.

401k plans are subject to early withdrawal penalties. The plan administrator may, but does not have to, offer a Roth 401k plan.

Upon reaching the age of 72, a plan participant must begin withdrawing required minimum distributions (RMDs) from their plan unless they are still working.

Transfer to IRA

An employee may, but does not have to, transfer a 401k plan to an IRA. Many people choose to do this upon retirement, or separating from their employer.

A traditional 401k plan would be transferred to a traditional IRA, while a Roth 401k plan would be transferred to a Roth IRA.

What is an RRSP?

The Canadian RRSP, known as the Canadian Registered Retirement Savings Plan, is one of several types of retirement plans available to Canadian workers. The RRSP is probably more similar to an individual retirement account (IRA) than a 401k.

However, there is a Canadian equivalent to the 401k that employers may offer. This is known as a group retirement savings plan (Group RRSP). In a similar manner to a 401k, a group RRSP allows Canadian employees to contribute money on a pre-tax basis, deferring their income until the money is withdrawn.

An employee or employer can only open an RRSP account at a financial institution approved by the Canada Revenue Agency (CRA).

Contribution limits

RRSPs are also subject to a contribution amount limit. Usually, the RRSP contribution limit is 18% of the employee’s pre-tax earnings from the previous year or a number established by the CRA. In 2022, the contribution amount limit is $29,210.

Any unused contributions under the maximum limit, known as contribution room, from one year can be carried forward to a future year. This allows a plan participant to maximize deferrals in years where they might experience significantly higher than normal taxable income.

Canadian employees can contribute to an RRSP until they reach the age of 71. After that, the plan must be converted to a registered retirement income fund (RRIF), which is subject to required minimum distribution rules.

Withdrawal rules

Like a 401k, a Canadian citizen may defer any taxable income in their RRSP from their tax return. The main difference is that a Canadian resident is not subject to early withdrawal penalties, should they choose to pull money out before reaching retirement age.

The only tax implications are simply reporting the amount withdrawn as ordinary income on the Canadian tax return.

What do a 401(k) plan and an RRSP have in common?

Tax deferment

Both a traditional 401k and RRSP offer tax deferral as a benefit for participation. As long as the contributed funds remain in the retirement account, the investments can grow on a tax-deferred basis.

Over time, the investment growth in a tax-deferred account offer significant advantages over holding those same investments in a taxable account.

Who can contribute to each plan

Although RRSP is an employee program, Canadian employers can help contribute to a group RSA. These contribution plans are very similar to the relationship that IRAs and 401k plans have for U.S. citizens.

Taxation upon withdrawal

Except for Roth 401k plans, both Canadian RRSP and 401k withdrawals are fully taxed at ordinary income rates. The main difference is that there are no early withdrawal penalties for Canadian retirement plans.

When it comes to tax planning, it’s important to recognize that a lump-sum withdrawal can cause significant tax implications in any given year. A tax-focused financial advisor should be able to help manage cash flow options to reduce the impact of a lump sum withdrawal.

Investment options

Both 401k plans and RRSPs offer the employee control over investment decisions within their plan. Most 401k plans allow the participant to choose from a variety of mutual funds that invest in the U.S. and global stock markets, fixed-income instruments like bonds, money market funds, or a combination of other investments.

RRSPs are similar in that they offer mutual funds which invest in a variety of investments depending on the investor’s risk tolerance.

What are the key differences between a 401(k) vs RRSP?

While RRSPs and U.S. 401k plans are similar, there are a few key differences between the two contribution plans.

How you can set up each plan

In Canada, any resident of Canada with earned income can set up their own RRSP plan, regardless of whether their employer offers an employee program or not.

Conversely, in the United States, an employee can only participate in a 401k if:

• Their employer offers a 401k plan
• They own their own company, and participate in an individual 401k plan. This is also known as a solo 401(k)

If an employer does not offer a 401k plan, then the employee’s tax deferral options are limited to IRA contributions. The IRA contribution limit is much lower than the 401k annual contribution limit. While you can still receive a tax deduction for IRA contributions, the tax savings is far less than for 401k plan participants.

Early withdrawal penalties

Canadian retirement plans do not have early withdrawal penalties.

Within a 401k, a plan participant is subject to early withdrawal penalties unless one of the following exceptions apply:

• They are at least 59 1/2 years of age, or are at least 55 years of age and have separated from the employer
• Upon death of the plan participant
• Upon disability of the plan participant (this must be a total and permanent disability)
• As part of a qualified domestic relations order (QDRO), which is issued upon divorce
• Participant withdraws money in a series of substantially equal payments, as applicable under the Internal Revenue Code
• Certain qualified withdrawals by military reservists called to active duty

Contribution limits & options within each plan

In Canada, an RRSP participant’s annual contribution is limited to the LESSER of:

• 18% of their taxable pay, or
• The annual limit as established by the CRA. For 2022, this limit is $29,210.

Conversely, a 401k has no percentage limitation on a participant’s ability to contribute. Similar to the CRA’s monetary limit, there is an annual employee contribution limit.

For 2022, this maximum contribution level is $20,500. However, employees who are age 50 or older can contribute an additional $6,500, for a total of $27,000.

Carrying forward contribution room

The major difference between the U.S. and Canadian retirement plans is that Canadian plans allow a participant to carry forward their contribution room to future tax years. This enables Canadian savers to save more in high income years.

Conclusion

To summarize, it might not be fair to pit the 401k vs the RRSP. Both are retirement plans that offer great opportunities for participants to defer taxable income in high income years. When they reach their retirement goals, thrifty savers can enjoy their hard-earned money at lower tax rates.

If you liked this article, please check out our tax-planning section, and our comprehensive tax planning guide!