Your annual RRSP contribution is based on your previous year's earned income minus a pension adjustment for any benefits you accumulated in a pension plan or deferred profit sharing plan from your employer. Your RRSP deduction limit is listed on the Revenue Canada Notice of Assessment you received following your last year's tax return.
When you contribute to an RRSP you can claim an equivalent deduction from your income before calculating your tax payable. This immediate deduction is very worthwhile, especially if you use the tax saved to make an RRSP contribution for next year or pay off after-tax debt such as your mortgage.
However, RRSP investments also accumulate within the plan tax-free. The longer your money stays sheltered from the taxman, the greater the earning power of your investment. The most powerful benefit of an RRSP is this tax-free accumulation.
Compare taxed and tax-free investment returns. Investors having a marginal tax rate of 40% who invest $1000 per year for the next 30 years at an average 10 per cent annual return, and pay tax as the profits are earned, will accumulate $79,060.
If the same investor contributes $1000 per year to an RRSP for the next 30 years and earns an average 10 per cent return, $164,490 will be accumulated. The investment has more than doubled when the income was tax-sheltered in an RRSP.
The real power of an RRSP is its compounding effect over a long period of time. Without the tax in the example above, it's like adding four per cent to your average annual rate of return, certainly nothing to sneeze at. With a high rate of return, RRSP contributions early in your life can go a long way toward providing for your retirement.
At any age, RRSP contributions are one of the very best investment strategies. You always get the tax deduction, and you always have your investment compounding tax-free.
Another good strategy is making "spousal" RRSP contributions. The higher-income spouse contributes to the lower-income spouse's RRSP. The higher-income spouse receives the RRSP tax deduction. However, when it's time to draw the RRSP contributions out, they go to the lower-income spouse at a lower tax rate, subject to certain restrictions. This is one of the few allowable ways to split income and is highly recommended.
Your RRSP rate of return is very important in determining the final value of your investment. Going back to our example, 6 per cent per year for 30 years makes you about $79,000 while 10 per cent per year earns $164,000. That four per cent difference really adds up.
Mutual funds specify objectives in their prospectus to investors. Some aim for growth, some for steady income, some for preservation of capital. Talk to your investment adviser about your investment objectives and capacity for risk. Your advisor can help you find the RRSP investment fund that is right for you.
But remember, start today. The sooner you contribute, the sooner you will lower today's taxes and begin accumulating your investment tax-free.
© 1997, Fiscal Agents Money Management Newsletter