How to maximize your RRSP for optimized tax-saving and long-term income
An RRSP (Registered Retirement Savings Program) is an amazing way to save for your future, adding true benefit if it’s managed properly. Investors usually get a tax refund in April and can start to build nest-egg for the future at the same time.
Too good to be true? Absolutely not.
However, the decisions you make during the term of your investment will greatly affect the amount of tax you owe (remember, it’s only deferred tax) when you retire or reach one of life’s milestones. Unlike other retirement funds that you simply cannot touch until you reach a certain age, tax-free withdrawals from your RRSP are always at hand. This works well for some, not so good for others.
Using your RRSP for life events makes perfect sense
For example, using an RRSP towards an equity deposit on a new home is a great reason to start young. With the Home Buyer’s Plan, a maximum of $25,000 can be withdrawn tax free, and be used for a good portion of your down payment on your first home. Then, rather than pay sky-high interest rates on a loan, you simply gear your budget to return the $25,000 back to the RRSP over the next eighteen years, interest free.
However, for those continually tempted to spend their tax refund or dip into their RRSP for unnecessary luxuries or because the budget becomes a little tight, it could cause a financial headache when the tax is due to be repaid further down the line. Each and every one of us works hard for our salary. We want our savings to do more than scrape above the rate of inflation. Furthermore, we all like to think we’re one step ahead of the tax man.
The RRSP – it’s place in Canadian economics
The RRSP product that was introduced in 1957 is only a shadow of the cover that we’re now availed of. The transparent mechanics combined with Government backing has proven to be an extremely popular combination with Canadians. Consequently, for the first two months of every year in the run up to tax deadlines, you can’t drive past a billboard or turn on the radio without seeing or hearing about RRSPs in one guise or another.
There are pitfalls with this type of Investment though. The difference between an RRSP and other types of Investments, however, is that you can control its destiny and avoid those potholes with the right foresight and a firm focus on the future.
Here are, the Four Top Tips for making your RRSP investment a success
Learn the difference between tax-free and tax-deferred savings
By using an RRSP as a vehicle to defer tax payments, the income tax savings are attainable from day 1. Furthermore, whether your fund grows or shrinks, you pay no tax on the accrued balance immediately, either. However, there will come a point in time when those taxes become due. It might not be today, it might not be tomorrow, but someday (hopefully way off in the future), you’ll begin to start repaying the accumulated tax as you use the RRSP to provide your income in retirement.
What are the limits of an RRSP?
Okay, we’ll split the answer to that question into two. Firstly, we’ll assume you’re paying in the maximum you can each year, then we’ll look at ‘carry-over’ when you don’t reach your full capacity. Assuming that you’re not going to be 72 this year (Dec 31st in the year you turn 71 being the upper qualifying age limit for contributions), for 2013 the maximum you can deposit into your RRSP is $23,820 or 18% of last year’s salary, whichever is the lowest amount. Should your company have contributed anything to your RRSP through their pension plan, that amount counts toward your total allowance. To put that into a practical example, if you earn anything less than $127,500 last year, the most you could save would be 18% of that sum, whatever it was you earned. If you earned more than $127,500 in 2012, you have reached the tipping point where the maximum contribution of $22,950 for last year, hence the most you can save, is less than 18% of your salary.
Carrying your allowance forward
Unlike many schemes that operate a ‘use it or lose it’ policy, Canadian Government RRSPs are not so inflexible. If you don’t use all of your maximum contribution limit one year, the balance can be added onto next year’s contribution limit. For people who don’t start their RRSP until their later years, this policy offers a great opportunity to invest much larger sums of money. Their allowance has accumulated over the years even if they’ve not saved anything in the Plan. A word of caution, if you find yourself with large savings to invest and plenty of leeway up to the maximum deposit limit. It’s still preferable to spread that deposit over several years to maximise the tax-free benefits of RRSPs, rather than invest it all in one lump sum.
As your savings grow, so do your RRSP taxes
We can’t stress enough that, by opting to join the RRSP, it’s not a message from the Canadian Government telling us we’ve been let off our taxes for life. The tax you have been refunded still has to be paid back, as well as taxes earned on the growth of the fund. That’s why it’s a smart move, when you get notified of your tax refund in April, to plough it back into the RRSP if at all possible. Again, we’ll look at an example. $200 dollars invested in an RRSP today will generally net you $60 tax refund in April. Now, imagine that $200 doubles in value and, when the time comes to repay the tax it’s worth $400. You have to repay the tax of $60 on the original investment plus the $60 on the similar growth. The net effect is you retain only $280 of the $400 as $120 is deducted in tax. When we take into account inflation, a return of $80 on $200 is okay, but not brilliant. If, on the other hand, you had put the original tax refund back into the pot and not spent it, you’d now have a disposable $340, instead. The net effect of repaying $120 tax is identical. But that original $200 has recorded an inflation-busting 70% increase, allowing you more comfort in later life.
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The RRSP, we believe, is the right investment choice for many Canadians. However, by over-contributing or treating your RRSP as the only vehicle to steer your savings comfortably towards retirement, you’ll not get the full benefit of this amazing savings opportunity.
Running an RRSP in tandem with another investment product and maximising the amount you’re due in retirement by topping up your fund with your Tax Rebate is the right way to look forward to life once you’ve clocked off for the last time.
It’s all about what you can keep from your stash rather than what your RRSP states that you have before tax.
Every case is different. Whilst the four tips are general, the only way we can give you an accurate estimate on how much you need to put by for the future and exactly which RRSP will suit you is if you call our office today.
We want your RRSP to play a part in your retirement, but for the right reasons, not because you’re so inhibited by the amount of tax deducted every time you withdraw funds, you become scared to do so.
Watch these RRSP videos to learn more…