Investing for Beginners – RRSP Accounts

As a Canadian of legal age, there is another tax-exempt account that you can open other than the TFSA account. As a reminder before we continue, as mentioned with the TFSA, with the current pandemic, you are actually able to open up your RRSP account online with any financial institution without ever needing to set foot in the bank. I mention this because there is no reason to not open a tax-exempt account as it is easy and can be done from the comfort of your home and is definitely a fantastic way to begin preparing for the future.

Like the TFSA account, a RRSP (Registered Retirement Savings Plan) is an initiative that was started by the Canadian government to help promote saving and investing for retirement to Canadians right when they begin working. By incentivizing Canadians to save early on, the government is able to reduce the burden on their social assistance programs for retiring Canadians now and in the future as this has pushed the burden of saving money for retirement to the average Canadian rather than the government.

So How Does an RRSP Work?

An RRSP works by depositing pre-tax income – depending on the company that you work for, this deposit can be taken directly from your pay slip before you pay taxes – into your account where this money can increase through the years. The benefit of an RRSP is that this money is pre-tax, meaning that you have not paid taxes on this money and therefore it would be much higher than if you had paid taxes on this money. You do not immediately pay taxes on the money going into your RRSP and you also do not pay any immediate taxes on the dividend income and/or capital gains that are made in your new RRSP account. Also, through the years, this money is never taxes as long as it is not withdrawn. Once withdrawn, this money is taxed at your marginal tax rate. This means that if you deposit money into your new RRSP account, you can deposit 100% of the money that you have made – without paying taxes – and any money that is made through compound interest in the account is also not taxed every year. For clarity, let’s use an example. You open a new RRSP account in 2020 and put $5,000 in the account and you never touch the account again. This $5,000 would be pre-tax money, meaning that you have not paid taxes on this income and it is coming directly from your paycheck, and it would go directly into your RRSP account. You decide to purchase a low-cost index fund that tracks the TSX and has approximately a 7% return with a 2% dividend and you decide to only hold this index fund for a single year before selling it. After your first and only year, your account would be worth $5,450. $5,000 from your original investment, $350 from your capital appreciation and $100 from your dividend. In a normal non-registered (or cash) account, at the end of the year, you would be expected to pay taxes on your dividend earnings and your capitals gains. Since this is a RRSP account, the benefit is that you would not be required to pay taxes on this $450 – please note that dividend earnings and capital gains are taxed differently – and the money that you save from having a tax-exempt account can actually be used to make more money through compound interest. Basically, the RRSP allows you to utilize 100% of your capital each and every year to maximize the returns that you can potentially make. 

One of the other benefits of the RRSP is that normally you would withdraw your funds at retirement – hence the name of the account – when you are taxed at a much lower tax bracket compare to when you were working and depositing money into your RRSP account. To clarify, the RRSP works best if you expect to be in a lower tax bracket when you retire than when you were working. As an example, if you are 30 years old and are currently making $50,000 a year and are being taxed at 28% and depositing money into your RRSP, this would be a great move if you are planning on only paying yourself in retirement $30,000 a year. If you are planning on making more money in retirement, lets say $100,000 which raises your marginal tax rate to 40%, than you would be taxed a greater amount of money when you withdraw from your RRSP in retirement than you would have paid through your working years. The reason why a RRSP is still worth it even if you are hoping to be making more money in retirement than you currently are now, is the following benefit!

One of the greatest benefits of the RRSP is that you can receive a tax deduction every year that you make a contribution so that you can pay less taxes every year. This means that if you deposit $5,000 into your RRSP this year and you currently make $50,000 a year, rather than being taxed as someone who makes $50,000, you would be taxed as someone who is making $45,000 a year. With this tax deduction, you are paying less taxes on your income and you have the benefit of the full $5,000 in your RRSP account that will make you money over the long-term. Also, as a reminder, you are allowed to withdraw funds from your RRSP whenever you want but if you decide to withdraw money from your RRSP before retirement, you will be taxed at your current tax rate which for some might be a substantial amount. 

Overall, the RRSP is a great incentive program to help you retire financially stable by incentivizing you to save every year to lower your taxes and to build up a retirement fund. After the TFSA, the RRSP should be the second account that you open once you have begun your investing journey. 

Comments

Let me know what you think! Would you change anything? Let me know in the comments!

Feel free to follow us on social media!

Instagram: @themillennialoptimist

Facebook Page: The Millennial Optimist