OddThoughts

I was having a conversation with a work colleague the other day regarding RRSP’s and taxes. I’m no money expert at all and I only have a slight understanding of the idea; at least how it works in Canada.

RRSP’s are “tax deferred”. Which means any monies you contribute to an RRSP, the tax is deferred to the time that you withdraw it (normally at retirement) the money is not taxed at the time you earn it.

The “theory” is that when you retire, you will require less income to live because many of the expenses (mortgage, kids, car) will be paid off. When you retire then you will be in a lower tax bracket and less tax will be taken from using it. (FYI: It doesn’t always work out this way)

So what does this mean for the average joe?

If you make say $40,000, normally the government will take a percentage (tax) of that $40,000. But if you took $5,000 of it and put it in an RRSP, then the government will only tax you at $35,000. Sounds simple right?

It gets a bit more complicated when you consider there are 2 ways you can contribute to your RRSP

1) You can have your employer put your contribution directly into the RRSP (ie: it never touches your hands)

2) You can take the money after you’ve received it from your employer and then put it it in an RRSP

If you choose Option 1) you can set it up such that tax on the amount you contribute is not taken off at source. So if you gross $40,000, tax is deducted as if you made only $35,000 and the other $5,000 goes straight to your RRSP

If you choose Option 2) then tax is taken off (withheld) the entire $40,000 at once, and later at the end of the year when you do your taxes. Basically the government will give you back the tax they withheld for the $5,000 you contributed.

Similarily, let’s take an example where you make $40,000, but you earned a one time bonus of $5,000 at the end of the year.

If your employer puts the bonus directly into an RRSP,your RRSP will then grow by exactly $5,000 (no tax is taken off)

If your employer writes you a cheque for the $5,000 bonus then you will not get the full $5,000 you will get $5,000 - the tax that the government witholds. So a $5,000 cheque may really only be about $3,000 in your pocket.

Now you can take that $3,000 and put in into an RRSP, and again when the end of the year arrives you can claim this $3,000 as non-taxable income and get a percentage back from what was withheld

So it is more of an advantage (when possible) to have monies transferred direct from your employeer into an RRSP then to have it touch your hands first.

Got it?

If so, then I will through one more gotcha into the process. An “investment analysit” or a financial planner migh put it to you this way:

If at the end of the year you make a $5,000 RRSP contribution, you will get an     additional $2,000 back in your taxes at the end of the year. In otherwords your $5,000 investment has an immediate 40% return ! So it’s a no-brainer to contribute to an RRSP.

Although this looks really nice; hopefully you can now see that techincally it isn’t “really” true. A $5,000 RRSP investment means that the government will give you back $2,000 of the money they withheld automatically from you, because since your bought an RRSP your taxable income is know lower and they should not have taken off as much tax as they did; therefore you are refunded your own money.

You didn’t “really” make money on the $5,000, you are just getting your own money back that you otherwise would not have recieved if you did not make the contribution.

In summary; RRSP’s are not a tax credit. It is a tax deferral. Typically tax credits refund you a portion of the tax you paid for certain expenses. (For example interest paid to your student loans) You don’t have to may as much tax on monies you paid on interest in Canada Student loans. (Yeah Canada!) You don’t have to pay any tax on monies invested in RRSP’s. At least until you try to withdrawl them.

At least that’s my understanding of how it works today in our current legal and economical environment. As always other comments are welcome and appreciated to set me straight!

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