Registered Retirement Savings Plans (RRSPs) are not new having been introduced in 1957 and the purpose has remained true to its roots – encouraging people to take responsibility for their own future financial independence. The Government does this in two ways. First, it allows taxpayers to deduct (up to the annual and cumulative maximum limits) RRSP contributions from our taxable income which reduces our taxes owing by our marginal tax rate. Afshin asks the logical question: what is a marginal tax rate?
Each person has a marginal tax rate that is calculated each year based on the combined top tax brackets (Federal and Provincial) based on their taxable income. For Afshin, who’s current income from employment is $52,500, his top combined tax rate or marginal tax rate (MTR) is 20.5% Federal (2016 rate) and in BC, his Provincial rate is 7.7% (2016 rate) for a total of 28.2% – his MTR. This means that on the last dollar Afshin earned, the Governments keep 28.2 cents and he keeps 71.8 cents. Since RRSP contributions are deductible from our last dollar earned, he will save $282 in taxes for every $1,000 he contributes. If he wanted to save $1,000 per year outside the RRSP, Afshin would need to earn $1,393, pay 28.2% tax ($393) and have $1,000 left to invest. By using the RRSP, he only has to earn $1,000.
On to the second key point about RRSPs – the Government does not tax growth in the fund as it occurs – only when you finally choose to withdraw the money – normally as a retirement income of some form. What does this mean to Afshin? Normally investment income or growth is taxed each year at his MTR. So for every $1,000 of investment growth each year, Afshin would pay an additional $282 is taxes. Let’s look at this another way – if Afshin’s investments earn 6% a year outside his RRSP, he will only keep 71.8% of that or 4.31%. Contributions of $1,000 per year grow to $104,623 by the time he is 65 years old. But inside his RRSP and growing at the full 6%, the $1,000 per year grows to $159,428 at age 65 – an INCREASE of 52.24%! The cost of waiting 1 year to start his RRSP is $9,998 since he only has 38 years to age 65, his fund will be $149,430 rather than $159,428 by starting today – nearly $10,000 for waiting one year.
Income required per $1,000 contribution $ 1,000 $1,393
Tax Paid before net contribution $ 0 $393
Gross investment earnings 6.00% 6.00%
Tax on investment earnings 0.00% 1.69%
Net investment earnings 6.00% 4.31%
Value at age 65 of $1,000 saving per year $159,428 $104,623
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