Continuing from yesterday… (you might want to go back and read it, if you haven’t)

The main benefit of saving to an RRSP is that any amount* you contribute is tax-deductible.  But what does that mean?

(*Note: there is actually a limit to the amount you can deposit in RRSPs in a year.  It’s 18% of your gross annual income up to a certain amount.  In 2009, the amount is $21,000. So if you make over $116,667/year… awesome :) , but you contributions are capped.)

For example, let’s say you earn $50,000, and are in a 20% (fictional, but for illustrative purposes) tax bracket.  This means, come April when you sit down to do your taxes, you’ll find that you owe the government:

Tax Owing: $50,000 x 20% = $10,000

Now, either you’ll have had the correct amount deducted by your employer, or you might have even paid too much tax, and you’ll get some money back in a refund!  But the worst case is, you may not have paid enough tax, and you’ll owe the government.

Continuing the example above, say that you maximize your RRSP contribution (by saving the whole 18%, as mentioned previously)

RRSP Contribution: $50,000 x 18% = $9,000

When you now calculate your income tax owing, you get to deduct (subtract) your contribution!

New Tax Owing:  ($50,000 – $9,000) x 20% = $41,000 x 20% = $8,200

Tax Savings: $10,000 – $8,200 = $1,800!

There’s even more tax savings to be had when your RRSP contribution drops you from a higher tax bracket to a lower one.

Now, you will have to pay income tax on the money you contributed eventually.  An RRSP allows you to defer your tax, that is, the government assumes that when you retire your income will be lower than while you were working and any income, in this case, paid from your RRSP will be taxed at a lower rate.  But the real advantage is that the growth of your investment through compounding interest, dividends, or capital gains are tax free as long as they are held in your RRSP!

If you do withdraw funds from your RRSP prior to retirement, you will pay a hefty amount of tax since it’s counted as income, and will be taxed at your highest marginal tax rate.  However, there are some exceptions! (Of course.)

Written by Juan William