RRSP Illustration

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

Tax = $9,000
Family expenses = $30,000	Invest-ments $5,000

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

Tax = $6,750	Invest-ments= $7,250 (RRSP)
Family expenses = $30,000

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If at the end of the 2nd year you decide to withdraw the money from the RRSP you must pay tax on the amount withdrawn.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.