Uncommon Cents: RRSPs (and taxes)

From Jan 1. to April 30, we are in the financial season of the year, when two sets of financial matters hit us. So, in my next column, I’ll talk about taxes. In this one, I’ll discuss the Registered Retirement Savings Plan (RRSP).

“RRSP” may sound boring and, if you are a student, it may seem like a matter you don’t need to worry about for quite some time. However, whether you are in a four-year program or study longer, you should have the term RRSP as part of your mental financial plan. Here’s why.

In the dying weeks of the St. Laurent Liberal government in 1957, the initial legislation that created the RRSP came into being. It was created to encourage Canadians to put some of their earnings into private savings so that they would not be forced to depend only upon social security measures for support when they retired. Before that, the only other means of saving money that was tax deductible and deferrable was through pensions, which some companies offered.

For 2013, a person can put up to $23 820 in an RRSP or a maximum of 18 per cent of their earned income in 2012 (whichever is lower), plus unused RRSP contributions from previous years (this is counted from when the contributor turns 18). Until anyone makes a reasonable amount of money, using RRSPs as a savings mechanism is not recommended. That is why I suggested in a previous article that students should put money into a Tax Free Savings Account (TFSA), leave it there and then put that money into an RRSP when they start out on their careers.

As mentioned, RRSPs are tax deductible and deferrable. When you put money into an RRSP, you are able to deduct a portion of your taxes. Let’s use an example: Marty makes $50 000 per year. He puts the maximum he is allowed (18 per cent of his wage) into an RRSP, which is $9 000 per year. He would get approximately $2 500 back in taxes (you can calculate this using an online RRSP calculator). If he were thinking long-term, he would choose to put that money back into his RRSP. With $9 000 going into his RRSP over 35 years compounded at 5 per cent, he would save up to around $850 000 for retirement.

One caveat to this scenario: if he maxes out his RRSP contributions every year, Marty would have to choose a different vehicle into which to put his extra monies. In this case, it might be a TFSA. In a previous article, I pointed out that this savings method is new (since 2009), and every Canadian 18 or older can put in $5 000 per year. The growth in the money is tax-free.

In addition, the RRSP is also tax deferred. In other words, while you save money on taxes year to year when you are contributing, the tax man gets some of the deferred growth on the money when you begin to withdraw it for income. So, when Marty retires and he wants an income stream from his RRSP, he will have to pay some tax back. At $50 000 per year, in 2012, in B.C., Marty’s tax bill will be around $8 600. His marginal tax rate (MTR) — the rate at which each of us pays tax, depending upon our salaries — will be about 29.7 per cent. When he retires, his MTR will decrease, depending upon how much taxable income he makes while in retirement. Let’s say he makes $25 000. His MTR would be about 23 per cent. In effect, he saves a good deal of money up front for every dollar he contributes through RRSPs to his own retirement by getting tax money back, and then he saves money when he has to withdraw from his RRSP for income.

Next up: taxes. Trust me, it is not boring!

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