Walk into any of the nation's financial institutions at this time of year, and you're bound to see signs inviting you to make an RRSP contribution for 2015. If you still use human tellers, odds are they'll raise the topic and if you're more partial to ATMs, an electronic reminder is apt to roll across the screen.
We'll assume for this article that you are a member of the millennial generation, aged somewhere between ages 18 and 34. There's been much press on how this generation is eschewing the bricks-and-mortar branch networks of the big banks but in practice, most Canadians still use one. It's likely where your paycheque is deposited.
That makes it convenient to automatically fund your RRSP with a pre-authorized chequing (PAC) arrangement — transferring funds directly from your main bank account into your chosen investment vehicle inside your RRSP.
But what exactly is an RRSP, you ask. For starters, RRSP is an acronym that stands for registered retirement savings plan. RRSPs were created in 1957 by Liberal prime minister Louis St. Laurent to encourage Canadians to save money for retirement. The thinking seemed to be that in modern life it's so much easier and tempting to spend your money as soon as you earn it. Ottawa reasoned people needed an incentive to defer instant gratification and save money for a long-distant future.
Think of an RRSP as the original tax-free zone for investments, whether stocks, bonds, mutual funds, ETFs or many other securities. That first year in 1957, the maximum we could contribute was only $2,500 or 10 per cent of taxable income, whichever was less. Today it's the lesser of $24,930 or 18 per cent of taxable income.
Governments are used to wielding the stick of the tax system and for RRSPs, it created two carrots. The one everyone thinks of is the upfront tax deduction on any money contributed to an RRSP. Say, for example, that you earned $40,000 in 2015, putting you in the lowest federal tax bracket of 15 per cent. Also assume that as an Ontario resident you pay an additional 5.05 per cent in provincial income tax (using KPMG data). Imagine further that you contribute $5,000 before the Feb. 29 contribution deadline.
Come April, when it's time to file your tax return for calendar 2015, that $5,000 is deducted straight from your taxable income. So, if your taxable income was $40,000 before you RRSPed, you can now tell the government your taxable income has been reduced to $35,000 because of your RRSP contribution. If your combined federal/provincial tax rate is 20.05 per cent, you'd get a refund of 20.05 per cent of $5,000, which is $1,002.50.
That's right, Ottawa will send you a nice refund cheque of $1,002.50 because of your $5,000 RRSP contribution. (The effect is more dramatic for those in higher brackets: if you're in the top bracket, the refund might be closer to $2,500, depending on the province).
But you have also saved $5,000 for your retirement, which, remember, is what Ottawa wants you to do. You have your $1,000 refund but you also have $5,000 in your retirement kitty. How good is that
It gets better. There is a second carrot being dangled in front of you. If you invested that same $5,000 outside an RRSP, every year you'd be taxed on investment income earned by that capital. If it were in a two per cent GIC, for example, you'd generate $100 in interest income and would have to pay 20 per cent in tax on that interest each and every year.
But if the $5,000 were in an RRSP (or a TFSA for that matter), you would NOT have to pay tax on the $100 interest income (or on dividend income or any capital gains).
So, to review: you got a $1,000 tax deduction upfront AND you saved $20 on taxable investment income. But remember that every year you'll be adding perhaps another $5,000 to your RRSP, and over 20 or 30 years that plus compound tax-free growth means your nest egg will grow to a staggering amount if you keep it up.
Too good to be true It may seem so when you're a young person just beginning to accumulate wealth, but Ottawa's upfront generosity is partly negated by the fact that one day when you retire, it intends to tax your RRSP once you start to draw income from it.
By that time, however, you may be in a lower tax bracket than when you contributed. It's a fair tradeoff for all those decades of tax-free growth. You'll have your own nest egg and will be less of a burden on the government, which otherwise might have to pay you full Old Age Security benefits and (if you had no other income sources), the Guaranteed Income Supplement.
Jonathan Chevreau founded the and can be reached at .