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Five tax benefits of RRSPs


An RRSP (Registered Retirement Savings Plan) is an investment account that helps you prepare for retirement by growing your money and sheltering it from taxes.

There are five main tax benefits of RRSPs that make them ideal for saving for retirement.

1. Contributions are tax-deductible

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 counting it as income later. In the meantime, you're not giving that income back, but rather setting it aside in an RRSP where it can be invested until you draw on it (generally during 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 presently.

2. Invest pre-tax dollars

Had you not made an RRSP contribution, you would have been taxed on that amount. You would have had less to invest with because you’d be paying tax on it. Put another way, you are investing pre-tax dollars as opposed to after-tax dollars.

We’ll discuss the tax applying to 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. You don’t pay tax on any income from those investments, which is why RRSPs are referred to as “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 benefits you even more over time through the effect of compounding.

Initially, only your own principal is invested, but as you earn income, that income is also invested, which generates income-on-income. Year toyear, this repeated reinvestment is responsible for a greater proportion of your returns. In time, it could exceed the interest you make 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

Tax deferral benefits you when it comes to your contributions and earnings. When you withdraw, tax is due. Even so, if your tax bracket is lower when you withdraw than it was when you contributed (the case for most people in retirement), you’re paying less tax on it than you would have paid earlier.

With that in mind, when you have a lower income (like if you’re early in your career), it makes more sense to delay making RRSP contributions. To be clear, you should still be saving towards your retirement, but you might want to start with another option, like a TFSA, and wait for your income to rise before contributing to an RRSP.

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

 

Learn more about RRSP options from Meridian

 

More resources

RRSP Basics: What you need to know
Choosing between an RRSP and TFSA
Minimize your taxes with a spousal RRSP
What is an RRIF and how do you use it?

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