For the first-time RRSP investor, it can be a challenge to understand how RRSPs can save you money. Contributions to your RRSP reduce your immediate tax burden, but you do pay tax on withdrawals. While it’s true that RRSPs may be more properly understood as a vehicle for tax deferment instead of savings, you may still pay less in tax in the long run. Here’s how the math works on RRSPs so you can make the most of this very popular savings vehicle.
How do RRSPs save taxes?
Contributions to your RRSPs reduce the tax you pay for your upcoming income tax payment. The amount of your contribution is tax-free for that year. For example, if you make $50,000 and put $10,000 in your RRSPs, you’ll only pay income tax on $40,000.
You do pay tax, however, whenever you take money out of the RRSP. It is added to that year’s taxable income. Here’s where you can save money with proper planning. If you make contributions during a high-income year, you save on income that would be taxed at a higher rate. If you then withdraw from your RRSPs during a low-income year (say your retirement years), your income may fall into a lower bracket.
Here’s the math: In the 2019/2020 tax year, Canadians pay 15% federal tax on the first $47,630 of income, 20.5% on the next $47,629, and the rates go up progressively. Any income over $210,371 is taxed at 33%.
That means that if you put $10,000 in an RRSP that would normally be taxed at 33%, you would reduce your taxes by $3,300. When you withdraw that $10,000 from your RRSP, ideally in retirement when your income is lower, you may pay less than you saved. Say your total income in retirement including the RRSP withdrawal was under $47,630, you would only pay 15% tax on the $10,000 withdrawal. That means you will pay $1,500 in tax on your $10,000 withdrawal in retirement after you saved $3,300 in your contribution year — meaning you’ve saved $1,800 in taxes.
Pro-tip: It’s important to note that RRSP withdrawals increase your income, which may affect your eligibility for government benefits. That’s something to think about when you are drawing up a financial plan for your later years.
Of course, some people save so well their retirement income may be higher than what they made earlier in life. In those infrequent cases, their marginal tax rate actually goes up. If you anticipate this happening, RRSPs might not be your best bet.
What about TFSAs?
The most common alternative to the RRSP is another tax savings vehicle, the tax-free savings account (TFSA). This investment does not save you tax in the current year. TFSA contributions are included in your income. However, the investment vehicles (which can include mutual funds, ETFs, GICs, etc) within the TFSA can grow tax-free. That’s because any money you take out of your TFSA is not subject to income tax. In addition, when you remove money from your TFSAs that withdrawal is not included as income on your tax return — so withdrawals don’t affect government benefit eligibility.
There are two main ways to invest in TFSAs – self-directed, meaning you manage your investments, or you can have a financial institution manage it for you. Which approach you take should consider your comfort level with managing money and investment goals.
Research Your RRSP Options
RRSPs in themselves are not investments – they are a vehicle into which you may place your investments. This means that money inside your RRSP can be in the form of several qualified investments including, but not limited to stocks, bonds, mutual funds, ETF’s, savings deposits, and GIC’s.
Many financial planners will say that you don’t have to think of RRSPs and TFSAs as an either-or proposition. In fact, they can be used in combination to help you develop the right mix of retirement savings. To learn more about your potential investment options, look at RRSP rates and options on RateSupermarket.ca to find the right mix for you based on your income, investment goals and life stage.