Your RRSP: The Key to Your Retirement

The Registered Retirement Savings Plan (RRSP) does not eliminate taxes; it defers them. What does that mean?

In our ongoing blog, we recently covered how a Tax-Free Savings Account (TFSA) can help your investments grow by shielding them from taxes. An RRSP, also protects your investments from taxes, but does it in a subtly different way. Contributions to an RRSP are made with before-tax income, making it a very powerful investment vehicle if used properly. Read on for details...

Deferred Taxes

If you buy a stock, mutual fund or ETF that does not pay any dividends or distributions, you would not pay any taxes until you sell it. Theoretically, you could continue buying more units of the investment over time, not sell any of it, which would delay when you need to finally pay taxes. At the time you sell the investment, you would need to pay capital gains taxes on any increase in the investment from how much you initially paid for it.

When you did sell the investment, the capital gains would be charged at a rate of half your marginal tax rate. This capital gains tax is thus often in the 15% - 20% range. If you managed to postpone the selling of an investment until you were retired, your marginal tax rate could be relatively low. This concept of delaying, or "deferring", taxes is at the heart of the RRSP.

The benefits of paying taxes later, rather than now, are that the compound interest rate on your investments would be higher because you are getting the equivalent of interest on interest. For example, let's say you have $10,000 and your tax rate is 25%. If the asset pays 4% every year, after 10 years you would have $14,800 and owe $1,200 in tax, giving a net gain of $3,600. However, if the 25% tax were applied to the gains every year, the net gain would be only $3,440. This benefit is even greater for higher tax rates (40% is more realistic), higher rates of return, or longer time periods.

Other Benefits of RRSPs

Other than sheltering your investments from tax, there are a few additional advantages to RRSPs vs. a standard investment account:

• Unlike the above example of holding a stock until retirement, or even a TFSA, investments in RRSPs are made with before-tax income. This means that you get additional cash equivalent to your full marginal tax rate to invest.
• Any distributions or dividends paid out that remain in the RRSP are tax-deferred.
• You can move cash between assets or asset classes within an RRSP without incurring capital gains taxes.

RRSP Contribution Room

Your RRSP contribution room for a given year, is calculated ahead of time, and is printed on your Notice of Assessment that you should have received after filing your taxes for the previous year. If you have never had significant income and need to file a tax return, then your initial contribution room is $0. This means that if you start off in a high-paying job, you may need to postpone contributing to your RRSP until the following year, when your contribution room has grown.

The contribution room to an RRSP is cumulative back to 1991, so unused contribution room (as well as unclaimed contributions) carry forward. Calculating the new contribution room for a given year is beyond the scope of this blog post, but it is 18% of your "earned income" with various adjustments, to a maximum of $23,820 (for 2013). In most cases, it is best to rely on the value provided on the Notice of Assessment. The government allows some leeway ($2,000) for over-contributions, but generally the penalty tax for over-contributions is higher than expected gains.

At CJ Capital, we offer our clients a comprehensive retirement education, which includes an RRSP strategy.

Be Wary of Withdrawals

As with a TFSA, it is typically easy to withdraw funds from an RRSP. That is, if you ignore the tax implications.

• Any RRSP withdrawals are taxed at your marginal income tax rate. Your financial institution is required to initially withhold a certain amount in taxes, and then at the end of the year you are required to pay the full marginal tax rate when you file your tax return.
• Unlike a TFSA, RRSP contribution room does not recover. If you contributed $10,000 to your RRSP in 2012, but then needed to withdraw it in 2013, that contribution room is gone permanently.
• Pre-mature RRSP withdrawals will reduce that portion of your retirement asset base. You may have less to retire on than you initially planned.

Taking money out of your RRSP for non-retirement purposes should be a last resort. When it comes time to withdraw money from your RRSP you should do so in the context of a financial plan to defer and minimize your taxes as much as possible, which CJ Capital can help you prepare.

There are often alternative ways to raise money with fewer tax consequences than withdrawing from your RRSP, such as using funds in a TFSA or standard investment account. There are a few specific cases when the government lets you "borrow" money from your RRSP (for example, to buy a new home or to pursue education), where the above points do not apply.