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The Companion Advisor: Taxes & Estates
How does an RRSP save me tax?
Stepping over the marginal tax rate barrier

A Companion Advisor Article

The information in is article is subject to change, therefore be advised its content should be viewed as illustrative to the context of the article. Income tax laws change over time therein rendering certain numbers quoted obsolete. Please consult current tax rules

RRSPs offer two substantial tax breaks. To really appreciate this, you should first be aware that Canada has a "progressive" - or escalating - income tax system.
That means the government set up a series of income levels with each level taxed at a higher rate than the one below it. Varying provincial income tax rates greatly complicate this structure, but generally:

Your first $6,500 or so of income is tax-free
The next $23,500 or so is taxed at about 25-29% depending on where you live
The next $29,000 or so is taxed at about 38-45%
On income above that level - $59,180 and over -you face tax of as much as 54%

How does your income fall into that lineup? The tax rate for your highest level of income is called your "marginal tax rate." For example, if you have $65,000 of taxable income, your marginal tax rate - the rate for the $5,820 that's over the $59,180 threshold - will be about 50-54% depending on the province you live in.

TAX BREAK #1
RRSP CONTRIBUTIONS ARE TAX-DEDUCTIBLE

This means you don't have to pay any tax now on the portion of your income that you put into your RRSP Suppose your contribution limit is $5,000 and you put in the full amount. Revenue Canada will let you subtract that much from your top level of income.

Immediate Tax Benefits

AT A MARGINAL TAX RATE OF	28%	43%	50%
Contribution	$5,000	$5,000	$5,000
Tax savings After-tax cost of a $5,000 RRSP contribution	$1,400	$2,150	$2,500
Total	$3,600	$2,850	$2,500

MARGINAL TAX RATE

In effect, the government is giving you an interest-free loan. The tax you would have otherwise owed now goes to work in your personal investment account. Or look at it this way: If your marginal tax rate is 50%, you have a choice between investing $5,000 in your RRSP or paying $2,500 in tax and then investing $2,500 elsewhere.

TAX BREAK #2
TAX-SHELTERED GROWTH MEANS MUCH MORE GROWTH

Normally, you must pay tax on investment earnings each year. With an RRSP, you don't. As with the up-front tax deduction on your contribution, that means money that would normally go to Revenue Canada can now stay in your RRSP and earn still more money.

How much more?

MONEY GROWS FASTER INSIDE AN RRSP

$5,000 ANNUAL CONTRIBUTION	RRSP	Unsheltered*	RRSP Advantage
Initial contribution	$ 5,000	$ 2,500	$ 2,500
Year 5	33,580	14,000	19,000
Year 10	87,660	33,020	54,000
Year 15	174,750	56,640	118,110
Year 20	315,010	86,800	228,210
Year 25	540,910	125,250	415,630
* at a 50% marginal tax rate. This table is used only for the purpose of illustrating the effects of the compound growth rate and is not intended to reflect future values or returns on any investment.