This is an exciting time of the year for finance geeks like me or people that get excited over things like updating spreadsheets!

I am a fan of RRSPs, TFSAs and all other tax deferred, tax sheltered vehicles because one of the sure things in financial planning is that taxes inevitably trend up over time.  

Even though we live in a country with relatively high personal income taxes, contributing to RRSP can still be a contentious topic. From time to time, I have heard people questioning the merits of RRSP.

Here are some of the objections:

1. Since not all of the gains in the investment portfolio are fully taxable, such as capital gains, is it wise to put money in an RRSP only to have all the withdraws be fully taxed as regular income?

2. Upon withdrawal, seeing a part of the hard-earned retirement income reduced by withholding tax can be heartbreaking.

But consider this:

1.    RRSP contributions can significantly reduce your overall taxable income in the tax filing year and enhance your retirement savings.

2.    Investment portfolios grow tax free while invested within the RRSP, and the interest compounding effect is magnified even more over longer-term time horizons.

3.    The difference between current and future income tax brackets matter. With some proper planning, overall taxable income in retirement should be lower than your peak income years.

4. Having a diversified set of income streams in retirement to draw on can maximize flexibility and tax efficiency.

Here is a numeric example of investing in RRSP vs. in Non-Registered account

We will keep the assumptions simple. The illustration assumes the investment has a 6% annual return of interest income and that you have a marginal tax rate of 40% each year.

Since contributions to your RRSP are effectively made with before-tax dollars and contributions to your non-registered account are made with after-tax dollars, the illustration assumes you have $10,000 to invest in your RRSP and $6,000 ($10,000 x 60%) after-tax funds to invest within your non-registered account. Lastly, for a simplified but complete net after-tax rate comparison, the illustration assumes you withdraw the entire amount from your RRSP and pay tax at your marginal tax rate of 40% at the 10-, 20- and 30-year marks.

For the purpose of the illustration we have kept the assumptions conservative but are still able to demonstrate a net benefit of investing in RRSP.

 

Source: RBC Wealth Management

Here are some helpful tips to make the most out of your RRSPs:

1.    You can contribute as early as the first day of the year and claim your contribution when you are ready to file for taxes.

2.    RRSP contributions are used to reduce your overall taxable income for the year, a short hand for calculating your tax refunds is to multiply contributed dollar amount with your marginal tax rate as an approximation.

3.    Does it make sense to borrow to contribute to your RRSP? It really depends on your income tax bracket and individual situation. Given the current low interest rates, I see more merits in the borrowing to invest but leverage should be used with caution and after careful consideration of your financial situation and overall financial plan.

Happy saving and investing!