Advantages of Contributing to an RRSP
Quite simply, a Registered Retirement Savings Plan (RRSP) is an investment plan registered with the Canada Revenue Agency (CRA).
That’s not to say that RRSPs are only for those who do not already contribute to some other method of retirement savings, like a pension plan. They too may be able to take advantage of the significant benefits that come from contributing to an RRSP.
There are essentially two significant benefits that make contributing to an RRSP a worthwhile component to your overall financial plan.
The first is the immediate tax savings resulting from a contribution to an RRSP.
Subject to some limitations that will be discussed later, contributions made during the year and within the first 60 days of the following year can be used as a deduction from income when your tax return is filed.
This deduction will result in immediate tax savings equal to your marginal tax rate, which could be as high as 48% (however, this rate will vary by province and income level).
Second benefit
The second major benefit from contributing to your RRSP is the tax-deferred savings.
The investments inside the RRSP may earn income such as interest, dividends, or capital gains. These earnings remain tax sheltered until they are withdrawn from the plan at which time they are taxable as income.
Given that the returns are not taxed inside the plan, this allows your investments inside the RRSP to continue to accumulate tax-free earnings that compound the growth of your investment.
Here’s an example:
Eric has invested $5,000 in a non-registered investment every year, which generates a 5% annual rate of return in the form of interest income. Assume Eric has a marginal tax rate of 46% (please refer to the AIC Tax Rate Card, available from your financial advisor, to find marginal tax rates for various provinces).
After 20 years, Eric’s non-registered investment after paying taxes on the interest income each year will grow to approximately $130,000, which includes $100,000 in contributions and approximately $30,000 in after-tax savings.
Nancy, on the other hand, has been contributing $5,000 into her RRSP on a yearly basis and is also subject to the same marginal tax rate of 46%. Her investments inside the RRSP are also generating a 5% rate of return in the form of interest income.
At the end of 20 years, Nancy’s RRSP will have grown to be worth approximately $165,000 consisting of contributions and accumulated earnings.
In addition to the value of the RRSP, Nancy would have also received approximately $46,000 in tax savings as a result of the annual contributions. If the annual tax savings of $2,300 were reinvested in a non-registered portfolio earning the same 5% interest income, then Nancy would have accumulated an additional $59,950 after tax.
Therefore, Nancy’s RRSP would have grown to $165,000 plus $59,950 from her tax savings reinvestment for a total value of $224,950.
This value compared to Eric’s non-registered portfolio makes RRSP investing worth considering.
