Five tax drivers of RRSPs
By Tax & Estate specialist, Doug Carroll BBA JD LLM(tax) CFP TEP
A registered retirement savings plan (RRSP) is an account that helps you save towards retirement in a tax-effective way. Through five key features, an RRSP account encourages you to save, lets you defer tax so you can accumulate more, and paves the way for you to ultimately reduce tax on your retirement income.
1. Tax-deductible contributions
For every dollar you place into an RRSP account, you can take a deduction against your income.
In a sense, you are declining to receive that income in the current year, in favour of taking it as income sometime in the future. Though that income is yours to keep, you are setting it aside in an RRSP where it can be invested until you draw on it, ideally during your retirement.
There are limits to how much you can deduct, based on historical income and past contributions, but it’s the mechanics of the procedure we’re focused on here.
2. Investing pre-tax dollars
Had you not made an RRSP contribution, you would have been taxed on that amount. That would have left you with less money to be invested in your hands directly as compared what you have available in your RRSP account. Put another way, you are investing pre-tax dollars as opposed to after-tax dollars.
3. Tax-sheltered earnings and growth
With the benefit of those larger pre-tax dollars, the next step in an RRSP is to start investing your money. As those investments grow and earn income, there is no tax to be paid, or as is commonly stated, an RRSP is “tax-sheltered”.
Some people prefer the term “tax-deferred”, given that eventual withdrawals are taxable. Until you withdraw though, there is more to be reinvested, which leads into the next topic – compounding.
4. Tax-efficient reinvestment and compounding
Just as using pre-tax money gives you more to start with, reinvesting tax-sheltered income can accelerate your growth. This is helpful at first instance, but gets even better over time through the effect of compounding.
Initially only your own principal is being invested, but as you earn income, it is also invested, which generates income-on-income. Year after year, this repeated reinvestment is responsible for an increasing portion of your returns, in time possibly exceeding what you earn on your own contributions.
This compounding effect is not exclusive to RRSPs, but it will be accentuated in an RRSP where the full amount of all earnings can be put to work without being reduced by taxes.
5. Tax deferral until withdrawal, likely at lower tax bracket
The topics covered to this point have helped you build your investments with the benefit of tax deferral on both contributions and earnings. Now on withdrawal, the tax is due. Even so, you will pay less tax by using an RRSP, assuming your tax rate is lower on withdrawal in your later years than it was in your working years when you contributed.
But what if you are early in your career at a fairly low income level? Most people will make the RRSP contribution and claim the deduction. That’s a smart savings habit, but you can also be strategic with the taxes. Instead of taking the deduction that same year, you can carry it forward to claim in a year when you’re at a higher tax bracket, making the deduction worth more.
The information contained in this article was obtained from sources believed to be reliable; however, we cannot guarantee that it is accurate or complete. This material is for informational and educational purposes and it is not intended to provide specific advice including, without limitation, investment, financial, tax or similar matters.