Throughout the course of the year, I get many questions from visitors at my website. Based upon these questions I can say with 100% certainty that there are a lot of people out there who may be experts in their chosen profession, but who really do not understand the basic purpose and uses for an RRSP. There is no shame in this and no reason for embarrassment. We can not all be experts at everything. It is far better to ask a question and seem silly then to not ask, make an error and prove it. When it comes to your money, don't ever be too embarrassed to ask questions.
I'll give you a couple of examples. One was the case of a very qualified dentist, well respected by his peers, who asked me about putting money into a self-directed RRSP for his son who was attending university. The other was the case of a person who had received an inheritance, had some RRSP contribution room and was advised by so called friends to contribute to an RRSP. The problem was that this person's income was such that they would not pay income tax even without the RRSP.
There are two very basic purposes for an RRSP. The first is to allow yourself to save enough money on a tax-deferred basis in order to provide a retirement income later in life. The second reason that people invest in RRSP's is to reduce the tax payable on last years income.
If you are going to university, or otherwise have a low income, are you going to get any substantial tax back by contributing to an RRSP? The answer is no. In these cases, it doesn't make sense to contribute to an RRSP. We often hear people say that if you put a dollar into an RRSP, the government will give you back 40 to 50 cents. These people are getting back nothing and will have to pay tax down the road when they take the funds out of their RRSP or RRIF.
In the two cases above, a person would be far better off to invest outside the RRSP, in something that would not attract tax, i.e., avoid earning interest and look for something that would earn a capital gain. Then later, perhaps after university when one's income is higher, take these investments and contribute them to an RRSP and then make use of the deduction.
Unfortunately, in the case of the person with the low income who had received the inheritance, they had already contributed to their RRSP. I advised the person to hang on to the tax receipt and to file it in a future year when their income would be greater and they could make greater use of it.
The next question is 'How do I know when I am better off to invest inside or outside an RRSP?'. Generally, if your marginal tax rate today is far less than it is likely to be when you withdraw your funds, you are better off to invest outside the RRSP. One of the first things you will need to figure out is your marginal tax rate. Fidelity makes this easy for you. If you go here: http://www.fidelity.ca/fidelity/cda/ext_app/tax_calculator_eng/1,,,00.html, you can type in your province and your income and your marginal tax rate is calculated for you. For example, if you are living in British Columbia and you make $20,000 per year, and you have just your basic credits, your marginal tax rate is 25.4%. That's roughly what you will get back by making an RRSP contribution.
The next thing you should do is consider what your marginal tax rate will be when you withdraw your funds. You could go back to the Fidelity tax planning web page and type in your expected income upon retirement. A person living in beautiful British Columbia with $50,000 in income and just the standard credits would have a marginal tax rate of 37.39%.
You could go through some simple but laborious calculations to determine whether or not you are better off with different marginal tax rates, growth rates and time horizons, but I have made it simple for you if you have Microsoft Excel. If you go here: http://www.rrsp.org/spreadsheets.htm you'll find a spreadsheet that allows you to type in the following:
You can then compare each of the alternatives and see which is best for you. Have fun. - Doug
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