Saturday, April 25, 2015

Canadian Taxes A to Z (2015): R is for RRSP, RRIF & RESP

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 starting with R. I've chosen to present you with three R acronyms today, because they're all very important to your taxes, and there's sometimes confusion among them when it comes to knowing how they save you on taxes.

Eighteen letters down, eight to go! And only five days left to tax filing deadline. Clearly I'm going to have to double up on posts for a couple of days. And figure out what in the world I'll do with X, Y and Z!

First up, RRSP, probably the best known and understood of the three acronym terms. Most know it stands for Registered Retirement Savings Plan. This (and all the other acronyms) 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." 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. Also, 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. The up front tax saving is probably still worth it, but be careful.

RRIFs are essentially forced withdrawal 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).

RESPs, in contrast to the other two vehicles, don't result in a tax saving to the person contributing in the year of contribution, but do permit the accumulation of investment returns tax free within the plan, which can then later be withdrawn tax free. 

Both RRSPs and RESPs are subject to annual contribution limits, and tax free withdrawal limits. You can even temporarily get tax free money out of an RRSP for specific purposes, like buying a home, but you'll be required to pay it back. 

It's important to consult an accountant or carefully study Canada Revenue Agency material each year that you intend to contribute to or make a withdrawal from a RRSP or RESP (and withdraw from a RRIF), as the limits, rules and exceptions continually change. But all three remain important tax saving instruments. 

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