As a recent grad, saving for retirement is probably the last thing on your to-do-list. I mean, retirement is in like 30/40 years you got lots of time to save for retirement… Right?
Life Expectancy in Canada
Well 50 years ago, the life expectancy was 70 years old. Today, in 2019 the average life expectancy is 80 years old! WOW that’s amazing… But let’s say you save only enough money to last until you are 80 years old, but then you live to 90+… Yeah, trying to go back to work at 90 years old does not seem very fun.
1. Reduction of TAX on EMPLOYMENT INCOME
In my previous article (Who do you ACTUALLY work for?) I explained how employment income is taxed.
Recap: Tax you pay = Taxable income * tax bracket.
Taxable income is the amount of income that the government is allowed to tax, while the tax bracket is the rate or % of tax. Ex. Your annual salary is $50,000 per year, that means you are in the 30% tax bracket. So the amount of tax that you pay is $16,000 (50,000*30%).
RRSP Benefit:
A benefit of an RRSP is that you can reduce your taxable income by the amount that you contribute to your RRSP. So let’s say you contribute 10% of your annual salary of $50,000 ($5000), you can reduce your TAXABLE income to $45,000. That means the tax that you pay tax only on the $45,000 instead of the $50,000, resulting in $1,500 less tax. Golden Rule of Tax: “The more taxes you can avoid paying today the better.”
2. Tax-free Returns on your Investment Income:
In a previous article (How to Invest to Make Money), you learnt that we get taxed even when we invest in stocks/shares.
Recap: Tax you pay = Taxable income * tax bracket.
Taxable income is the amount of income that the government is allowed to tax, while the tax bracket is the rate or % of tax. Ex. Your annual salary is $50,000 per year, that means you are in the 30% tax bracket. So the amount of tax that you pay is $16,000 (50,000*30%).
RRSP Benefit:
So a benefit of the RRSP is that you don’t need to pay taxes on the investment income that you make. (This is the same benefit as TFSAs).
Analogy: Here is my cute plant analogy again. Think of the RRSP as a pot that holds all your plants. The plants represent all your investments (stocks/shares). If your plants are in the pot, it protects them from the outside elements aka taxes.
Drawbacks: An RRSP is not without its flaws
- Contribution Limit: 18% of annual salary, with a max of $26,500 per year. (link to calculate RRSP limit)
- Only Deferred Tax: With an RRSP, you only defer the amount of tax that you pay. When you take out your money you have to pay tax based on your respective tax bracket.
- Less Flexibility: If you have money in an RRSP and decide to take it out before retirement, you have to pay taxes to take the money out, so it is less flexible.
How to use an RRSP for recent grads:
In my opinion, the best benefit of the RRSP is the initial tax deferral on your employment income. However, for recent grads (if you’re making between $40,000-$70,000) you are still in a relatively low tax bracket. So it’s best to save this tax deferral once you are making 90,000+. So you should still invest 5-10% into your RRSP, but you should first focus on maxing out your TFSA. The TFSA is more flexible in when you can use the money and you don’t need to pay any tax once you take out the money.
Now stop reading and go to your employee portal/bank to set-up your RRSPs and TFSAs if you haven’t already! Share this article with a friend who might find this useful! 🙂
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