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The five tax drivers of RRSP’s


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A registered retirement savings plan (RRSP) is a government-sanctioned investment account designed to help you save towards retirement in a tax-effective way.

Through five key features, an RRSP encourages you to save, allows you defer tax so you can accumulate more, and gives you the opportunity to ultimately save tax on your income in retirement.

1. Tax-deductible contributions

For every dollar you place into an RRSP, you can take a deduction against that year’s income.

In a sense you are declining to receive that income in the current year, in favour of taking it as income some time later. In the meanwhile, you are not giving that income back to the place where you earned it, but rather setting it aside in an RRSP where it can be invested until you draw on it, generally meaning your retirement.

There are limits to how much deduction can be taken, based on historical income and past contributions, but it’s the mechanics of the procedure we’re focused on presently.

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 to what could have arrived in your RRSP. Put another way, you are investing pre-tax dollars as opposed to after-tax dollars.

We’ll discuss the tax applying on RRSP withdrawals shortly, but for now the result is that there is more available to earn investment income.

3. Tax-sheltered earnings and growth

So with the benefit of those larger pre-tax dollars, the next step in using an RRSP is to start investing those funds. 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, as we’ll cover in a moment. Until withdrawal though, there is more to be reinvested, which leads into the next feature – 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 obviously helpful at first instance, and gets even better over time through the effect of compounding.

Initially only your own principal is being invested, but as you earn income then that income is invested, which generates income-on-income. Year to year, this repeated reinvestment is responsible for a greater proportion of your returns, in time possibly exceeding what you make on your own contributions.

This compounding effect is not at all 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

The features covered to this point have helped you build your investments with the benefit of tax deferral on both contributions and earnings. Now on withdrawal, tax is due. Even so, you will have reduced your taxes by using an RRSP, assuming your tax rate is lower on withdrawal than on contribution.

With that in mind, if you are at a lower income when considering a contribution than where you expect to be in retirement, for example if you are early in your career, it will make more sense to delay making RRSP contributions. To be clear, you should still be saving towards your retirement, but you’ll have to wait until your income rises before an RRSP fits your needs.

Your financial advisor can help you determine where you are at, and how to take best advantage of these RRSP tax features.

Speak to your Meridian Wealth Advisor for perspective on these important issues.

Follow Doug on twitter: @realtirement

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