Let's start with the basics. A registered retirement savings plan (RRSP) is simply a plan registered with the Canada Customs and Revenue Agency (CCRA) that is designed to encourage you to help save for your retirement. Basically you agree to put a portion of your salary or self-employment income away, and in return the government gives you an immediate tax deduction. You won't face tax on any contributions until you withdraw the money from the plan.
But wait, there's a catch. The Department of Finance won't let you put as much money into your RRSP as you may want to each year. They set contribution limits that are based on your earned income. Earned income includes employment income, rental income (less losses), self-employment income (less losses), royalties, alimony, maintenance and taxable child support received, and disability pension income received under CPP/QPP.
Earned income does not include interest, dividends, capital gains, pension benefits, retiring allowances, severance pay, death benefits, scholarships or bursaries.
The maximum amount that can be contributed to an RRSP in any given year is set as the lesser of 18 percent of earned income of the previous year, and a limit set by the Department of Finance. Currently the limit for 2001 is $13,500. This means that a taxpayer who made $75,000 of earned income in 2000 could make the maximum contribution of $13,500.
We've defined the maximum amount of money that a person can put into an RRSP each year. But suppose there aren't enough funds available to make the contribution — is that contribution room lost forever? Thankfully no. Any unused contribution room can be carried forward and used in a future year. Which brings us to an important point. Did you know that Canadians have a combined unused RRSP contribution room of $176.4 billion? In fact, some individuals have unused contributions in excess of $30,000. Why is it so important to get money into your RRSP today? First, it provides you with a tax deferral. An RRSP contribution made today provides you with an immediate tax deduction, therefore reducing your taxable income. You won't pay tax on these funds until they're taken out, so you're effectively pushing your tax bill to a future year.
Kaitlyn decides she needs to use up some of her excess contribution room and makes a $2,000 contribution to her RRSP. If her marginal tax rate is 50 percent, she'll save $1,000 in tax that she otherwise would have paid. If she leaves this money in her RRSP for 40 years and withdraws it when her marginal rate is still 50 percent, she'll pay $1,000 in tax at that time. What has she saved? Well, paying $1,000 some 40 years from now is the same as taking $46 today and investing it to earn 8 percent. In 40 years, she'll have the $1,000 needed to pay her bill. By deferring the tax, she has effectively reduced her tax bill to $46!
Another advantage of contributing to your RRSP today is tax-free growth. You see, any income you earn inside your RRSP is not subject to tax until the money is taken out. So, regardless of how large your investment grows, you won't pay tax until the future. Since you're not paying tax on the growth, you're left with more money at the end of each year to compound inside your RRSP.
Suppose you make a $100 contribution each month to your RRSP. You earn about 9 percent on these funds. If you leave the money for 30 years, you'll have $183,000 when you retire. Compare this to contributing $100 each month outside your RRSP. Assuming your effective tax rate is 40 percent, you'll have only $89,600 when you retire. How's that for proof of the benefit of tax-free compounding?
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