Understanding the ABC’s of RRSPs

(article courtesy of Fidelity Investments)

Imagine, if you can, a scenario in which the Canadian government pays you almost half of the money you require to make the investment of your choice. A GIC or a hot stock — it’s your call. Then, when you’ve made money on that investment, be it through interest earned on the GIC, or the capital gain generated by the sale of your stock, the government tells you don’t have to pay tax on it. Keep the profits they say. No hitch. No hassles.

Sound far-fetched? Not at all if you are among the one in three Canadians currently taking advantage of the federal government’s most generous form of tax relief — the Registered Retirement Savings Plan — commonly known as the RRSP.

An RRSP is a government approved program that is designed to encourage Canadians to save for their retirement by providing powerful tax reduction options. The tax breaks come in two forms. The first is that once you set up an RRSP, the financial contributions you make are deductible from your taxable income.

Taking an example from Gordon Pape’s 9 Low Risk Ways to Get (& Stay) Very Rich, this means that people in the middle tax bracket whose marginal combined federal/provincial tax rate is somewhere around 42%,(depending on which province you live in), would receive a tax refund of $2,100 on a contribution of $5,000. Therefore, the “real” cost of the investment is only $2900 but the full $5,000 is still working inside the plan.

The second tax advantage resides in the sheltering of the income and capital gains that are generated by the investments in your RRSP. Simply put, your money is allowed to grow tax free. Anyone who has ever invested in a GIC (outside of an RRSP) knows that the interest earned is heavily taxed. Likewise, a capital gains tax is levied on investments like stocks and mutual funds. But all investments within an RRSP are effectively “sheltered” from tax and allowed to compound.

Using the example once again of the RRSP holder in the 42% tax bracket, let’s examine the effects of a five-year $10,000 GIC paying 10% interest held both inside and outside an RRSP. In a sheltered plan where no tax is paid, the investment would grow in value to $16,105 in five years. Outside of an RRSP, the investor would be required to pay $2,357 in tax resulting in a cumulative value of only $13, 257.

But why you ask, would the government in these desperate times of budget slashing and tax grabbing allow itself to miss out on such lucrative revenues? Aren’t governments supposed to encourage consumer spending, not saving?

The answer may well be simpler than the question. Governments are broke. They quite simply do not have the resources to continue to support the growing number of retired Canadians who will be dependent on government-sponsored pension plans in the future.

RRSPs are one method by which the federal government can encourage people to take responsibility for their financial future.

At the risk of providing too much of a good thing, however, the government has established limits as to how much an individual can contribute to an RRSP on an annual basis. The yearly maximum allowable contribution limit is currently 18% of the prior year’s earned income up to an annual maximum.

Once you’ve determined the amount of money you can afford to put into your plan, the next decision must be where to invest. Fortunately, there is a plethora of options. Among them Canadian equities, international equities up to an allowable limit, mutual funds, Treasury Bills, bonds, stripped coupons, GICs and the list goes on. It is best to explore your options with a financial advisor – one who can help you identify the options that are best for you. After all, it’s your money and your future.