Today in Canadian Taxes A to Z, we come to the letter R. Unlike that stumper letter Q, R presents an embarrassment of riches when it comes to choosing tax-relevant words. I've chosen to present you with two R acronyms today, because they're very important to your taxes, and there is sometimes confusion when it comes to knowing how they save you on taxes.
Eighteen letters down, eight to go! And only four days left to tax filing deadline. Clearly I'm going to have to pick up the pace. And figure out what in the world I'll do with X, Y and Z!
RRSPS ARE REALLY ONLY A TAX DEFERRAL VEHICLE
First up, RRSP. Most know it stands for Registered Retirement Savings Plan. This is a tax deferral vehicle, not a tax free vehicle. Meaning, you get to save on tax when you deposit money to it, and the taxman gets you when you later withdraw money from the plan.
In theory, RRSPs are supposed to save you money in two ways. First, because the dollars you deposit to your RRSP are pre-tax dollars, there are more of them to deposit, and thus more of them available to earn a return on investment. That's probably going to mean you have somewhere between 50% and close to 100% more money invested up front (depending on the level of your marginal tax rate).
Thus if you've got $100 to invest, and you put it into an after-tax outside of RRSP investment account, you'd really only be investing $75 dollars (if you're paying tax at 25% - many of us pay at a higher rate). If you're able to invest at a 5% annual rate of return, that $75 investment would be worth only $78.75 after one year. Whereas, if you had placed it into an RRSP you'd have $105 after one year. And all the benefits of increased compounding in future years.
The second way RRSPs may save you money is that when it comes time to withdraw from the plan, you'll be retired, and earning a lower income (and thus be in a lower tax bracket) than when you originally contributed to the plan. The important word to focus on here is "may."
WHY RRSPS COULD BE BAD FOR YOU
Many people don't realize that it's entirely possible they could actually be earning more money later in life than earlier in life, such as if they're collecting a pension and also still working full or part time. Additionally, the government could decide at some point to raise marginal tax rates. You'll get hit with whatever rate is in force and applicable to your current income at the time you make the withdrawal, not the rate applicable when you made the deposit. The up front tax saving may still be worth it, but be careful.
RSP investment earnings also don't benefit from Canadian dividend capital gains tax breaks, any any other kinds of breaks for special kinds of investments. Everyone gets taxed when withdrawing money from an RSP as if it is just interest income, regardless of how the profits were generated.
RRIFS ARE FORCED RRSP WITHDRAWALS
RRIFs are essentially forced withdrawals from RRSP plans, starting at age 71. The government won't force you to withdraw too much each year, but your RRSP must be converted to a RRIF by age 71 at the latest, and the withdraws increase as you get older.
The idea seems to be to force you to pay some tax on all the RRSP accumulation while you're still alive, rather than leaving it to your heirs to be hit with the tax (which might be at the top marginal rate if all those RRSPs become income to you in the year of your death).
Thus you should think twice before deciding that the best place to stash all your excess cash (however much or little that might be) is in a RSP.
Gordon S. Campbell is a tax lawyer practicing throughout Canada who has argued tax cases as high as the Supreme Court of Canada. He also litigates other kinds of civil, criminal and family law cases, as well as practicing immigration & citizenship law. Learn more at www.acmlawfirm.ca/gordonscottcampbell