Party now, pay later
RRSP is short for Registered Retirement Savings Plan. The idea with this type of investment account is to avoid paying tax on some of your income today and instead pay it after you retire.
There are two advantages to this
One, it is likely that you will be in a lower tax bracket when you retire. And two, being able to invest more of your money now will lead to a bigger nest egg when it comes time to spend it.
Here’s a simplified example: If you made $10,000 and paid income tax at the highest marginal rate of about 50%, you’d have $5,000 left to invest. If you earned 6% annually over the next 20 years, you’d end up with about $16,000. Next, you’d have to pay tax on the gains you made. If you were in a retirement tax bracket of, say, 30%, the taxes on your $11,000 profit would be roughly $3,300, leaving you with $12,700 after all is said and done. Now, if you put that $10,000 in your RRSP instead, you’d pay no income tax on it. You could invest the whole $10,000 at 6% annually for 20 years, and end up with $32,000. This time, you’d have to pay tax on the full amount, not just the profit. But at a retirement tax rate of 30%, you’d still be left with $22,400, or nearly twice as much money.
And also some limitations
One of the limitations of an RRSP is that you are only given contribution room of 18% of your income each year with a cap of roughly $25,000 per year (this figure usually increases a bit each year). The good news is you can carry forward unused contribution room from previous years. Check the Notice of Assessment from your most recent tax return to see how much total contribution room you have available. You can take money out of your RRSP at any time, but there will be withholding tax just like a paycheque.
The exception is when you take money out of your RRSP to buy your first home or to return to school as a mature student. There are programs that allow you to “borrow” from your RRSP for these purposes without paying tax, as long as you pay it back into your RRSP within 15 years for home purchases or 10 years for school.