While most individuals recognize the benefits of investing in a Retirement Savings Plan (RRSP), many do not exploit its unique advantages to their fullest potential. There are three primary benefits to investing in an RRSP:
Contributions to an RRSP are deductible for tax purposes within certain prescribed limits. In the year a contribution is made to an RRSP you can choose to deduct the contribution from your taxable income. This deduction reduces the amount of taxable income and thus the tax payable. The actual tax savings will depend on your marginal tax rate.
The table below outlines the amount of tax saved, and the after-tax cost of a $1,000 RRSP contribution based on various marginal tax rates.
The most significant opportunity offered by an RRSP is the tax-deferred compounding of income earned within the plan. The term "tax-deferred " refers to the fact that all income earned within the RRSP accumulates tax free until withdrawn.
If you have $10,000 to invest and have the choice of making an RRSP contribution or not making an RRSP contribution, consider the chart below, which shows the difference between investing the money inside and outside an RRSP (tax-deferred versus taxed). Remember, if you invest the money in an RRSP, you will save $4,000 in tax (assuming a 40% tax rate). Therefore, a $10,000 contribution to the RRSP is comparable to a $6,000 investment outside the RRSP, assuming the tax savings are reinvested.
As you can see from the chart, you would be better off contributing to the RRSP. The question is, how much better?
To determine the RRSP advantage we have to convert the RRSP value to an after-tax value. To provide this comparison, let’s assume you will withdraw the $21,589 accumulated by the 10th year and pay tax at 40% on this income. In the unlikely event the RRSP is actually collapsed in the 10th year, you would still have $3,364 more by investing in the RRSP. Allowing the money to remain in the RRSP after the 10th year will further enhance the benefit to you.
Utilizing income-splitting strategies between spouses can provide significant tax savings. One of the most simplistic, yet effective methods of income splitting between spouses is achieved by contributing to a spousal RRSP. The objective of this strategy is to provide both spouses with similar retirement incomes and thus similar income tax rates in retirement.