“My sister/father/neighbour/co-worker told me that RRSPs are ‘bad,’ is that true?” This question has long surprised me in my career because of how often it comes up!
Registered Retirement Savings Plans (RRSPs) are a tool in your financial toolkit that, when used correctly, can be extremely advantageous. When used incorrectly, they can be extremely frustrating.
Think of RRSPs as income deferral. RRSPs operate by reducing your income when you contribute and increasing your income when you withdraw the funds. For example, if you had a salary of $80,000 and contributed $5,000 to your RRSP, you could deduct that contribution and pay tax as though you earned $75,000 that year. If you take that $5,000 out from the RRSP in a year where you’ve earned $25,000 already, you’ll add that amount to your income and pay tax as though you earned $30,000. The end result is you’ve deferred $5,000 of income from one year and claimed it in another.
Advantages of RRSPs include:
• They allow you to defer income from years where your income is high (your working years) to years your income is low (your retirement years).
• The money you contribute grows on a tax-deferred basis; you’re only taxed when you withdraw it.
• They provide the potential for you to increase your purchasing power, if the investments within your RRSP grow at a rate greater than the rate of inflation.
Considerations for RRSPs:
• If you buy RRSPs in years where your income is low, or redeem in years where income is high, the tax breaks don’t work in your favour.
• Not being aware of the details of the tax breaks could harm your retirement planning.
Let’s take a look at the context around tax breaks. For example:
Imagine a retiree who contributes $50,000 to their RRSPs over the course of their working career. At retirement, the value has grown to $100,000 and they’re shocked to find out that they would pay 30% tax on redemptions. That math leads to only $70,000 of purchasing power. Turning $50,000 into $70,000 doesn’t sound very exciting does it? On closer inspection, we find out that they earned a 40% deduction on all of their contributions. The tax break means the RRSPs really only cost $30,000 ($50,000 x (1-0.40)) net of taxes. Converting $30,000 to $70,000 sounds much better, right?
How should you use RRSPs to be successful?
1. Take advantage of the tax breaks as best you can! Save contributions for high earning years.
2. Consider re-investing the tax refund from your RRSP contributions, or apply it towards debt, to maximize the financial return on investment.
3. Invest your RRSP funds suitably for your retirement goals. If your account isn’t growing, at least with the rate of inflation, your purchasing power is being eroded each and every year.
Funding your retirement with RRSPs isn’t right for everyone! However, RRSPs are a core component to many retirement strategies, as long as they’re used correctly. If paying less tax today and increasing your income in retirement are among your goals, keep your mind open to using RRSPs! To learn more about how RRSPs could fit into your retirement or financial security plan, give me a call!
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