A registered retirement savings plan, typically known as an “RRSP,” is a great way to defer your taxes and save for retirement — but if you’re not using it correctly you could be sacrificing thousands of dollars.
Here’s a quick look at this investment tool and how you can use it to retire with more. I’ve also included an example to illustrate a good RRSP investment strategy at work.
What is an RRSP?
Simply put, an RRSP is an investment with special tax treatment.
The majority of RRSP contributors are motivated by the upfront tax savings, it’s most obvious benefit. Assuming an average tax rate of 33% (yours could be higher or lower, depending on your income) a $10,000 contribution could shave $3,300 off your current tax bill — deferring it until retirement when you are (presumably) in a lower tax bracket.
But tax deferment is only one part of the equation.
The real advantage to investing with an RRSP happens when you put your money to work for you.
How to grow your RRSP
I am often shocked by how many RRSPs are sitting in cash or savings accounts because the investor focused on the tax deduction and neglected to make a long-term investment decision.
An RRSP is technically a trust for the investor — it allows for special tax treatment (the upfront tax deduction) and, more importantly, the tax is also deferred on any gains made on the investment.
This means that your money will continue to grow and compound tax-free, so you have more to invest.
But simply having money in an RRSP is no guarantee that you’ll retire comfortably, as the growth of an RRSP is determined by its contents — if you don’t invest the money in the RRSP (in mutual funds, for example) it’s almost like putting it under a digital mattress.
Your investment can’t grow unless you take some kind of action.
Benefits of investing with an RRSP — a tale of two investors
To best illustrate the benefits of investing through RRSP contributions, let me tell you a tale of two investors (both are hypothetical and simplified for this illustration).
We will assume that both investors:
- Have $10,000 to invest
- Are invested in the same common stock that grows at 8% for the next 20 years
- Are in the same tax bracket (we will assume 33%)
The first investor is going to invest using a regular investment account.
The investor pays the $3,300 taxes owing ($10,000 x 33%), and invests the remaining $6,700 ($10,000 - $3300).
Because the growth in the mutual fund includes interest, dividends, and realized capital gains, the regular investor will pay some tax each year, and will earn about 6.4% (a combination of interest, dividends and capital gains taxed at their respective rates) after tax.
At the end of 20 years, the investor will have $23,169 with no taxes owing.
Now compare that to the second investor, who invested using an RRSP.
The investor puts the entire $10,000 in an RRSP account and it’s invested.
Because the 8% growth is tax-deferred, the original investment grows to $46,610 at the end of 20 years — but is fully taxable.
If the RRSP investor controls how much he takes into income, and pays the same 33% tax rate, he will be left with $32,627 — considerably more than investor one.
It’s also important to note that the majority of RRSP investors are in a lower tax bracket in retirement, so this example probably exaggerates the amount of tax owing.
In this example, the combination of having more invested upfront plus the deferred tax on the growth, led to the value of the investment in the RRSP being worth $9,458 more after tax than the investment from a regular investment account (approximately 40%).
Want to know more about investing with RRSPs?
This is just one example of how you can benefit from investing with an RRSP.
Although most people purchase RRSPs for the initial tax deduction, the real value of your RRSP lies in its ability to grow — and compound — tax free.
If you’d like to know more about how you can make your RRSP work for you, simply contact the team at Bick Advisors. We’re always happy to help.