RRSPs – The Taxman Giveth A Bone

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Deciding to invest your retirement money in something like the S&P 500 is an important step in setting up your personal finances. Being able to safely grow your money is important, but so is avoiding paying as much tax as possible when it’s time to retire and begin withdrawing from your savings.

Taxes are one of the three main agents of money corrosion (fees and inflation are the other two). If you follow the law, you will always pay some taxes. The trick is to figure out how to pay as little as possible.

Because the Canadian Pension Plan (CPP) pays out so little (currently $640 – $1060 per month), the government has given Canadians an incentive to take care of their own retirements by introducing Registered Retirement Savings Plan (RRSP).

RRSPs are a type of investment account that is registered with the government, they are designed to defer tax payments until you retire. They are not themselves accounts, but an account designation. That means that many types of bank accounts can be used as an RRSP: savings accounts, web broker accounts and mutual funds can all be designated as RRSPs.

The idea behind RRSPs is this:

When you are working, you are making much more money than when you retire. That means you are also paying more income tax too. By putting your money into an RRSP, you get a tax break next time you file your income taxes. If you make $100,000 per year, and you invest $18,000 into RRSPs, the tax break you get is the difference in tax you would pay if you made $82,000 instead of $100,000. The government lets you pay less income tax when you put money into your RRSP.

But later in life, when you retire and start tapping into your RRSPs, you pay regular income tax on whatever you withdraw. Because what you withdraw when you retire is likely to be less than what you made while you were working, you would be paying less income tax on that retirement income. Withdrawing $50,000 a year (for example) will still require you to pay income tax as though you had a regular income of $50,000. But a $50,000 income is in a significantly lower tax bracket than $100,000, you would end up paying far less tax overall.

Not only are you paying less tax when you invest in an RRSP, the money you get back allows you to immediately invest it so that you have even more money that can grow over the years.

Some RRSP facts:

  • The maximum amount you can contribute for 2015 is $24,930, or 18% of your income, whichever is lowest.
  • You can buy and sell equities (stocks) and take a profit in an RRSP without paying any taxes.
  • You cannot contribute if you are 71 or older.
  • You can withdraw up to $25,000 to help with the down payment on your first home, but you have to pay that amount back within 15 years.
  • If you can’t contribute the maximum amount, the difference will be carried over to the next year.
  • You will be charged 1% per month if you contributed more than your contribution limit.
  • When you are ready to retire, you need to convert your RRSP into a Registered Retirement Income Fund (RRIF). You can do that at any time.

Because the money you get back from the government when you contribute to your RRSPs is based on what income tax bracket you are in, the higher the tax bracket, the greater the tax break. But if you are in a lower income tax bracket, the benefits of contributing diminish. You can use an RRSP contribution calculator to see what you would get back from the government if you contributed to your RRSPs.

Using an RRSP calculator, you will notice that if you live in Ontario, make $40,000 per year and contribute $5,000 you will get a return of $1003. But if you make a salary of $100,000 and contribute $5,000 your return more than doubles to $2170.

RRSPs are a great way to help grow your money tax-free, but they are designed for average to above average income earners or households. If that’s not you, that’s OK, because Tax Free Savings Accounts (TFSAs) offer an even better way to save your money, and the benefits of TFSAs apply equally to everyone, as I will explain next week.

 

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