Don’t overlook the RRSP contribution advantage
February 26, 2015
The annual RRSP season is winding down. The last day to contribute and use the tax deduction for 2014 is March 2nd.
Seriously consider making a contribution if you have not already done so. Years from now you will be happy you did.
An RRSP which stands for Registered Retirement Savings Plan is the most popular savings vehicle in Canada. It was introduced in 1957 to encourage Canadians to save for retirement.
The strongest attraction for contributing is the tax benefits and there are many different tax advantages available with an RRSP investment. Your contribution can be claimed as a tax deduction to reduce your taxable income and therefore reduce your income tax.
In addition, savings within an RRSP grow tax-free while they remain in the plan but are fully taxed when they are withdrawn. The advantage is taxes can be deferred for years and possibly decades.
There are a few income tax considerations to know about. What is the marginal tax rate during the year of using a contribution as a tax reduction and what is the anticipated income tax rate at the year that the funds will be withdrawn.
For example, if you save taxes at the rate of 40 per cent for every dollar contributed, then pay income tax during retirement when the RRSP funds are withdrawn at a lower rate of say 25 per cent, then you have reduced your payable taxes.
Most Canadians will likely be in a lower income tax bracket when funds are withdrawn during retirement than they were during their working years. In that case an RRSP contribution makes perfect sense.
If it is anticipated that you will be in a higher income tax bracket during retirement, then the tax cost of withdrawing funds might offset the tax advantage of claiming those deductions in earlier years when you were at a lower income tax rate.
One consideration to be aware of is that future RRSP withdrawals during retirement will increase your taxable income. This could lead to the reduction of government benefits including the Old Age Security allowance.
Once you have invested in an RRSP, try to resist the temptation of withdrawing funds. Treat your RRSP as your own personal pension plan that will grow and only be used when you have retired.
In theory that makes perfect sense. However, in reality some individuals do have a habit of withdrawing funds from their RRSP. Then when retirement happens, those individuals will be without sufficient RRSP funds that are needed to meet the desired lifestyle.
That is the difference between employees who have workplace pension plans and those who contribute to their own RRSP. A pension plan does not allow the individual to make withdrawals.
More Canadians are relying on RRSPs because most employers do not want to assume the financial obligations to pay a pension to their retired former employees. Pension plans are still used extensively by various government employers.
For the vast majority on non-government workers you will be contributing to an RRSP. That requires ongoing decisions about contributing from one year to the next. We suggest trying to assume you will contribute every year.
An excellent way to do this is to establish an automatic monthly saving plan with contributions going to your RRSP. Every month the financial institution you have your RRSP with will take money from your bank account and contribute to your RRSP.
At some point you will be retired and for most a significant RRSP will be the difference between living the kind of lifestyle you would hope for and not being forced to dramatically reduce your standard of living.
We recommend you make regular RRSP contributions.