You've heard of them before, you know the basic information about them, but is an RRSP right for you? Here are four questions answered that will hopefully help you make the right decision.
Question 1: How does an RRSP work?
You're a smart person, so you probably already know this but just in case you need a refresher. RRSP season is the first two months of the year (although you can contribute to one all year long). If you put money into an RRSP during this time, you can use the deduction against last year’s taxes owing.
When you make a contribution to your RRSP, the government will deduct this from your income so you get taxed at a lower rate. The higher your income, the bigger bang for your buck because you are in a higher tax bracket.
If for example, you make $40,000 and you live in Prince Edward Island, your marginal tax rate is 28.80 per cent. A $1,000 contribution will give you a refund of $288. If you make $90,000 in the same province, your tax rate is 37.20 per cent. So a $1,000 contribution would give you a refund of $372. Each province has different tax rates so you need to take that into consideration when you’re calculating your RRSP savings. Click here to find out what your marginal tax rate is in your province.
Who doesn't want free money, right? Not so fast, this isn't new money; it's a refund of what you have already paid the government in taxes. If you are getting a tax refund it's because you have essentially given the government a tax-free loan for the year. so don't rush out and book that vacay just yet, be smart with the money and reinvest it!
Question 2: Will this money be needed for something else?
Money going into an RRSP should be earmarked for three financial goals only. First, retirement. Second, the first-time home buyers plan. (Check out our blog post on this here!) Lastly, full-time school tuition. (You can read about the Life Long Learning Plan here.) If you are saving for anything else, such as children, wedding, trip, home reno or debt repayment, the RRSP doesn’t support these goals.
When you put money into an RRSP, the government will deduct it from your income. If you earn $40,000 a year and make a $1,000 contribution, you get taxed like you made $39,000. So, you owe less at tax time. This is the refund mechanism.
Too good to be true, right? Sort of, here's the catch: When you take money out of the RRSP, it gets added back to your income. If you need that $1,000 contribution to fix your roof, the $1,000 is added back on to your income, and you get taxed like you made $41,000. Bummer. So, ensure that you don’t need money that goes into an RRSP in the short-run unless it’s for a first-time homebuyer down payment or for full-time school.
For all of you self-employed entrepreneurs and hustlers out there take note, you only get a percentage of what you contribute back, so don’t put all your savings into your RRSP! If you do, you will only reduce a portion of your taxes owing, and will still be facing a doozy tax bill.
Question 3: Do you make enough money to make it worth it?
The higher your income, the bigger bang for your buck with RRSP contributions. So, if you’re in a low tax bracket, contributing money to “save taxes” doesn’t make as much sense as it does for someone who has a higher income. You’ve got the rest of your life to increase your income and tax rate. Maybe 10 years from now, you’ll be dominating in your career and sleeping on a bed of money like Walter White from Breaking Bad (maybe choose a different profession than his though.)
The beauty about RRSP room is that it never goes away, so you don’t have to use it now. If you’re making peanuts now, don’t feel compelled to dump a bunch of money into an RRSP to save taxes. You’re not paying that much tax anyway. Wait, my friend … wait until you really are paying high rates and then dump all the money in.
Question 4: What happens if you don’t contribute to an RRSP?
Don’t worry, you’re not a financial criminal, and you’re not going to go to debtor’s prison. If you’ve got extra savings, you may want to consider the tax-free savings account. The TFSA is like the sexy best friend of the RRSP. If your savings are earmarked for goals that aren’t aligned with the RRSP or you don’t earn enough (yet) to really get a big bang for your buck on RRSP tax savings, put your savings into a TFSA, (we wrote about RRSPs vs TFSAs a few months ago, click here to read that post.)
The TFSA doesn’t offer the tax deduction (that fun refund thing that the RRSP has), but it is also tax-sheltered, like the RRSP, so it’s a great place to save money. Plus, when you take money out of the TFSA, it doesn’t get taxed. Ever. Period, full stop. So, it doesn’t matter what you’re saving for, the TFSA can support those goals.
If five years from now, you’re a big baller and your income tax bracket is 43 per cent, you can take all of the money you saved in the TFSA over the years and dump it into the RRSP (assuming you’ve got the room) and save boat loads of tax money at that point when you’re getting back 43 per cent of everything you put in. Clever.
Contributing to your RRSP is never a “bad thing” but it makes more sense for some people than others. Ensure that it makes sense for your income and your goals before you get caught up in the RRSP frenzy. Don’t forget, the TFSA is relatively new in town, but boy, are we glad that it’s here.
If you are still confused as to whether an RRSP is right for you or not, give us a call or send us a message, we're here to help!