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RRSP
Illustration
Suppose your annual
income is $44,000. You consider that $30,000 of your income will go
to cover the family expenses during the year. You must pay tax on
your income and are planning to save the rest of the money for
future needs, for example, for retirement. Assume that your
investments bring you 10% of additional investment income
each
year.
1.
Non-registered account.
You might pay tax on
your income ($44,000) equal to $9,000. In this case the amount you
can invest in non-registered account is $5,000.
Annual Income = Family Expenses + Tax
+ Investments (non-registered account) = $30,000+$9,000+$5,000
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Tax =
$9,000 |
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Family
expenses = $30,000 |
Invest-ments
$5,000 |
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You
have to pay tax on your investment income
each year. Suppose
your investment income will be taxed at the rate 31%, and
the rate of
return on your investment is 10%.
At the end of the 1st
year you will have in your
account:
$5,000 + $500 - $155 = $5,345
($155 – tax on the investment income $500x0.31)
At the end of the 2nd
year you will have:
$5,345 + $535 – $166 = $5,714 |
If you withdraw the money from the
non-registered account at the end of the 2nd year you will get
$5,714.
2. RRSP
account.
If you earned
$44,000 this year and spent $30,000 on the family expenses you may invest
$7,250 in the RRSP (registered account). In this case you will not pay
tax on the money invested, and your taxable income will drop to $36,750.
Therefore, the tax you have to pay to the government this year
declines by $7,250x0.31=$2,250 (assuming that your marginal
tax rate is 31%; rounded numbers). Instead of paying this money to a
taxman you put it in your registered account and start to earn
investment income on it.
Annual Income = Family Expenses + Tax
+ Investments (RRSP) = $30,000+$6,750+$7,250
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Tax = $6,750 |
Invest-ments=
$7,250 (RRSP) |
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Family
expenses = $30,000 |
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You do not
have to pay tax on your investment income unless you
withdraw money from the account.
At the end of the 1st year
you will have in your RRSP:
$7,250 + $725 = $7,975
At the end of the 2nd year
you will have:
$7,975 + $798 = $8,773 |
If at the end of the 2nd year you
decide to withdraw the money from the RRSP you must pay tax on the
amount withdrawn. Provided your annual income does not change
significantly and your marginal tax rate remains at
the same level (31%) you will pay tax $8,773x0.31 = $2,720 and the
rest ($8,773 - $8,773x0.31) = $6,053
will be yours. That means you earned in RRSP $339
more than in the non-registered account. This difference will grow with
number of years the money stay in the account. For example, in five
years the difference will be
$8,057-$6,980=$1,077.
Best scenario. If your annual income
in the second year declines to $25,000, your marginal tax rate will drop to 21% and you
will get ($8,773 - $8,773x0.21) =
$6,931 from the RRSP after tax. As regards the non-registered
account, you will have: $5,345 + $535 –
($535x0.21) = $5,768 in this
account at the end
of the 2nd year. That is $1163
less than you can get if you withdraw the money from RRSP in two
years and pay tax on it.
Worst scenario. If your annual income
in the second year increases to $73,000, your marginal tax rate will
grow to 37% and you
will get ($8,773 - $8,773x0.37) =
$5,527 from the RRSP after tax. At
the same time, you might have: $5,345 + $535 – ($535x0.37) =
$5,682 in your non-registered
account at the end of the 2nd year. That is
$155 more than you can get after
withdrawing the money from RRSP in two years and paying tax on it.
It is supposed that retired people have
a low income and may be subject to a lower tax rate, therefore the best
scenario will realize. How to protect your savings against the worst
scenario is a different story -
call me to know it.
The above information is
limited and for illustration purpose only. It is intended to provide
you a general overview of how RRSP works. Contact your accountant to
calculate your tax return.
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