By Janice Desautels (photo by Michael Thorner)
From now until the end of February, we will be overstimulated with messages about contributing to an RRSP. So when it comes down to it – what should we be doing?
It is a common misconception that an RRSP is an investment. Firstly, the term RRSP is an acronym for Registered Retirement Savings Plan. This is a federally sponsored program that the Canadian government implemented to encourage us to save more for our retirement.
Secondly, it is a choice to register an investment under the terms guided by the plan. Simply put, think of an RRSP as the vehicle and the investments as passengers. The vehicles can be anything you choose whether it be an RRSP, TFSA, Open Investment, etc. and the passengers can be your choice of a long list of investments that can participate.
Why is it a deal?
The deal is in the tax treatment. The income to be invested has been taxed according to the tax bracket it falls into. When you contribute to an investment that has been registered as an RRSP, the rules governing the plan stipulate that contributions can be tax-free. Hence the reason why you would get a tax refund after declaring the contribution on your tax return.
Some may misinterpret this as “free” money but it actually is a tax payment returned back to you. The downside to this method is that it is returned to you without interest but the upside is you are saving for your retirement (as long as you save the refund).
In essence your money goes in tax-free. It then grows within the investment tax deferred, meaning you have no tax charges while the investment stays within the realm of the registered plan.
The tax implication from using this method comes during the withdrawal phase of the funds from your investment to use as retirement income.
Where in our financial lifetime does an RRSP strategy fit?
Contributing to an RRSP strategy as the first step to saving for your retirement may not be the best to maximize your saving potential. For example, if you are starting out in your career, you may be at the first level tax bracket.
If you are confident that you will remain in this tax bracket throughout your career and then have saved enough to remain at this tax bracket in retirement, then what gain have you achieved? The gain will be very little purely calculating the comparison in tax.
However, as you move through your working life, it can be conceivable that you move up into higher tax brackets, save more, and can retire with a higher income pushing you into a higher tax bracket.
If you received the tax relief at a lower percentage than the tax bracket in retirement, then you really didn’t maximize the strategy as you would be paying a higher percentage of tax in the future.
The use of other strategies when your earning opportunities are growing could be of better use for maximizing your saving potential. I’m sure you would agree that our pot of money is not infinite and to get the best bang for our buck comes with some planning.
We now have another means to bridge the gap to when the RRSP strategy would be the most optimal, and that is another federally sponsored plan referred to as the TFSA – or Tax Free Savings Account. Contributions into an investment registered by this type of plan are after tax dollars.
We do not receive any tax refund on our contribution, but as the funds grow in the investment, like in the RRSP vehicle, it does grow tax deferred. What makes this strategy advantageous is when we choose to use these savings as an income stream, it will be tax-free. We can contribute $5,500 a year, and if you’ve not contributed to date, the ceiling is $31,000.
Both vehicles are worthy savings strategies. Talk to a qualified financial professional to help guide you to make the best decision to maximize your savings potential now and in the future.
Janice Desautels has been working with families and individuals for the last seven years helping educate in the field of financial literacy. She is a Certified Financial Educator with over 15 years experience in teaching and training adults.