Income tax

There are moments in people’s lives that aren’t exactly milestones, but they have a special feeling to them. Imagine getting a Happy Meal and they accidentally put an extra toy in, or how about when you want to park downtown and the meter you park at already has a bunch of time on it? Ever get a chocolate bar at the vending machine, only to have two fall down? Tax time has something almost on the same level.

When you get your tax return, it’s like Christmas in spring. Through no work of your own, you happen upon a few hundred or even thousands of dollars. That money is meant to balance out the expenses you “had” to pay for as opposed to the ones you didn’t. If you remember correctly, one of those was your RRSP contribution. Since that money is a tax deduction, the government considers it money that you’re not spending for yourself and so they give you a tax break on it. Before you start clapping your hands and squealing, I’m got to ruin the party and snap this back to reality.

How Taxes Work With Your RRSP

If you have $1000 and you made a 10% gain, you’d now have $1100. If it was a non-registered investment, you’d be taxed on that $100 gain. When you put money into your RRSP, the taxation on the growth is deferred to the day you take that money out. Interestingly enough, many advisors will tell you that the dollars you’re using for an RRSP are before-tax dollars, since you get that tax back on your tax return. Here’s the big kicker: that money that went into the RRSP is still with after-tax dollars.

When you retire and take it out, it’s taxed again. So, what’s the point you ask? There’s still the deferral of tax, but the thing that everyone overlooks is that in order for that money to be true pre-tax dollars, you need to put that tax return into your RRSP. You see when you get your paycheque, the tax has already been taken off. So, it’s already been taxed. In order to have the effect of that money being untaxed in your RRSP, it basically means holding off on that extra bowl of pho or that extra pint of beer.

Example Time

Just to put this into perspective, imagine you made $40k last year. Your tax rate would be approx 25%. If you were paid bi-weekly, your cheque (after taxes) would be about $1153.85. A good saver would put a minimum of 10% away into saving, which in this case would be $115.39.

Of course, you’re working with a kick ass money guy who grows your money at an average return of 10%. After 10 years, that $115.39 would have grown to $299.29. When you take that money out, you’ll be taxed at your marginal tax rate, which assuming you haven’t gotten a raise in 10 years, would still be about 25%. And so, from $299.29, you instantly drop to $224.47. Ouch!

Help Is On The Way

If you don’t have the discipline to save your tax return, there are other options. Your TFSA would fit the bill perfectly. Compared to an RRSP, they’re very similar with two major differences. But that’s for another post.