One of my key goals for 2019 is to figure out what I should be doing with my money (aside from making monthly payments to my student loans – shoutout to my fellow lawyers, #foreverindebt). If you’re in the same boat, or just trying to figure out some basic financial goals for a savvy young professional, join me for the ride!
In my Money Talks series, I’m going to be right there with you, figuring out financial literacy for non-experts who just want to be smart about their hard-earned cash.
Spoiler alert: right now it may seem like you’re going to remain forever young (kind of like Jay-Z), but someday, eventually, in a far away universe, you are going to retire.
Yes, really. And when you eventually do retire, you’re going to need some money because you won’t be working anymore (woo!), which means you aren’t going to be collecting a paycheck (boooooo). You’re going to need a strategy so that you don’t end up retired with no savings and nothing left to feed yourself but endless piles of clothing you purchased at the Zara semi-annual sale last year.
…I might be projecting here.
How Do These Things Work?
A Registered Retirement Savings Plan (short form, “RRSP”) is a specific type account that allows you to delay paying income tax on the amount that you put into the account until the time when you need to withdraw it. You usually have to pay taxes on your income, but if you put your income into your RRSP, then you get to put off paying the income tax on that amount until you actually use it.
Sound complicated? It’s not! Let’s say you’re 30 and you get paid $100,000 in one year. All year, your employer has been taking tax deductions off your paycheck in order to pay the government your fair share of income tax, based on your salary of $100,000 a year. But let’s say that at the end of the year, you put $20,000 of your $100,000 income into your RRSP.
Here’s what would happen: the government would give you some money back when you file your taxes, because now it’s as if you made only $80,000 instead of $100,000. You don’t have to pay income tax on the $20,000 you put into your RRSP, but since you already paid the tax on it through your paychecks, you’ll get some money back!
Here’s the other really cool thing about RRSPs. You also don’t have to pay taxes on the increase in value of the money sitting in the account. Let’s say you took the $20,000 in your RRSP and invested it all in Apple stock, and then the next day it magically doubled in value (I wish it were this easy). You invested $20,000 in stocks and then ended up with $40,000, so technically you earned another $20,000. But your money gets to grow tax free as long as it is sitting inside the account! The government won’t make you pay any taxes on this increase in value until you withdraw any of that amount from the account.
FREE MONEY!!!!!!! WOOOO!!!!
So What’s the Catch?
I’m not going to BS you – of course there’s a catch. You only get to put off paying the income tax on the money you put into your RRSP as long as it is still in your RRSP. Once you withdraw money from your RRSP, the government treats it as income again and you have to pay taxes on it.
Let’s go back to our example. One year later, you’re 31 and you make $100,000 in income again that year but you also withdraw $20,000 from your RRSP for some reason (maybe you bought yourself a new car). The government will consider this as you earning $120,000 that year – because now you have to pay the tax on the $20,000 that you put it into the RRSP. Remember, your employer makes tax deductions from every paycheck assuming you’re only making your total salary – so if you ‘earn’ an extra $20,000 in income from a RRSP withdrawal (which your employer obviously doesn’t account for), you will most likely have to pay some income taxes out of your pocket once tax season rolls around.
So Why Is This Important If I’m Young? I Need Access to My Money NOW.
Short answer: (1) because you’ll get a tax break, which means more money in your pocket at the end of the year, and (2) because once your money is in the RRSP, you’ll be less tempted to touch it – which allows it to grow.
Longer answer for (2): think of the term RRSP like a label for an account rather than a type of account. You can make a RRSP savings account (where you basically park your cash and just let it sit there) or a RRSP investment account. So here’s why (even though your needs for money are probably really high right now between rent, down payments, weddings, and vacations) one of the most important things you need to do for your RRSP is start saving – Right. Now.
There’s this magical thing called compound interest. You can learn more about how compound interest works here, but I don’t want to bog down this post. Basically, compound interest means that your money grows bigger according to (1) how much money is in the account, (2) how much the money grows as you invest it, and (3) most importantly, how long you leave the money sitting in the account.
I hear you asking me right now from the other side of this screen – does a few years of savings really make that much of a difference?
Yes. Yes it does make that much of a difference. It makes so much of a difference that it will shock you.
If you contribute and invest the exact same amount of money into a RRSP over a forty year period vs a twenty year period, in the forty year period you would likely end up with double the amount of savings. Double. Despite having contributed and invested the exact same amount of money in both scenarios, just in different periods of time.
Don’t worry, I get it. I felt the exact same way when I started reading out about all of this financial crap. You don’t need to understand all the math behind it to know that the value of investments (usually) increase exponentially the longer that the money is invested in the market.
So when you factor in the importance of compound interest, then the whole scare factor of having to pay taxes when you withdraw from your RRSP actually a good thing – it protects you from yourself and keeps the money in the account, where it will earn way more for you.
What if I Need to Use All My Income Now, Though?
You can still put some of money into a typical savings account (although you will be paying taxes on it) while you’re putting some of your income into a RRSP (tax-delayed). It doesn’t have to be all or nothing.
Also, this should be a huge relief – you can actually withdraw up to $25,000 from your RRSP tax-free if it’s being used for your downpayment for your first home purchase. This is a huge advantage for young couples/first-time home buyers. Of course, some financial advisors would say if you care about compound interest, it’s probably in your best interest to leave this money in the RRSP and just wait longer to save for the down payment.
FYI if you’re wondering where you should put your savings that you intend to withdraw more regularly, the answer is usually a TFSA – the topic of my next article!
What Happens When I Retire and Need to Start Withdrawing Money?
Like I explained above, the second you take money out of your RRSP, it’s considered income that you have to pay taxes on it. This is why RRSPs are so good at helping you save for your retirement – because it doesn’t really make sense to take the money out of the account until you are retired and your income is low enough to pay low taxes.This encourages you to let it sit there and grow instead of using it!
Canada works on a tiered-tax system, meaning you pay more taxes the more money you make. So let’s go back to our example from when you were 31, making $100,000 and taking out $20,000 from your RRSP – meaning the government would calculate your income at $120,000 that year and tax you accordingly. If you wait, instead, until you’re 75 to withdraw that money and your only income is your pension (let’s say $50,000) a year and you make a $20,000 withdrawal from your RRSP, the government will only tax you as if you made $70,000 – which has a lower tax rate than if you had paid taxes on the money when you were making $100,000. You basically got to pay less tax on that $20,000 by waiting to use it as ‘income’ when you were retired rather than using it when you were young and making a higher salary.
What is this ‘Deadline’ I Keep Hearing About?
Money you put into a RRSP is called a ‘contribution’. There’s a RRSP contribution deadline for every tax year. TIf you make a contribution to your RRSP before this day, then it counts as a deduction from your last year’s income.
So if you want to make a contribution for the 2018 tax year, you need to process the contribution before March 1, 2019.
What’s a Contribution Limit?
That brings us to contribution limits. There’s a limit to the amount of money you can contribute to your RRSP each year (otherwise, some people would contribute their entire paycheck and never have to pay income tax – which the government doesn’t want). The contribution limit is 18% of your income to a maximum of approximately $25,000 (it changes each year), plus any leftover contribution room from previous years.
For 2018, the upper limit was $26,230, so that’s the max you can submit by March 1, 2019 and you can add any leftover room from previous years. There are penalties you have to pay if you accidentally contribute too much to your RRSP, so be aware of how much you put into the account!
So How do I Know if a RRSP is for Me?
Like any financial product, RRSPs aren’t for everyone. You should always consult a financial professional before buying, opening, or investing in a new product. I get that you want a yes or no answer, but I can’t give you that. I don’t know your finances! If you went and borrowed payday loans to make RRSP contributions, for instance, that would be a terrible idea. If you have a ton of money sitting unused in a savings account, doing nothing for you, that’s a different question altogether. It all depends on your unique financial situation.
Instead, I’m gonna give you a list of things that you should consider – like a pros/cons list, except this one won’t get you in trouble like Ross with Rachel (oops, did I just age myself?).
Generally speaking, RRSPs work well in the following kinds of situations:
– you have a lot of money sitting in a savings account, which you’ve paid income tax on
– you can make a contribution that takes you under the next lowest tax bracket (this will usually get you a big return)
– the annual income you’re earning now is more than the amount you’ll earn in retirement
– you eventually want to buy (your first) property and need to start saving for it
Generally speaking, RRSPs might not be so advantageous in the following situations:
– you’re earning income that puts you in the lowest couple of income brackets, which you can check here (meaning you don’t pay a lot of income tax anyway)
– you’re earning less now than you plan to in retirement (i.e. you’re in the first couple years of owning a company) and don’t need the tax break
– you have a high amount of high-interest debt (i.e. credit cards) and you don’t have the money to pay that off and contribute to your RRSP at the same time
The Finish Line
We’re done! Your homework now is to do some honest thinking about how much money you’re spending on things you don’t need (daily Starbucks lattes + getting your nails done every two weeks + a gym membership you’re not using) and whether it would be better to contribute at least some of that money to your RRSP instead.
My way of dealing with RRSPs: I know that I am a spender, not a saver (online shopping is my weakness), so I set up automatic monthly contributions to my RRSP through my bank. Because of that, I don’t even have to think about contributions as ‘saving’ – it just feels like I make a little bit less income per month, so I’m not tempted to spend it.
Remember to go talk to a financial professional if it sounds like RRSP contributions would suit you – you’ve got about three weeks to make a contribution before the deadline!
Disclosure: This article is meant to provide basic, general information and does not provide any kind of legal, financial, or professional advice. Always contact a qualified and/or licensed professional for any personal or specific advice you may be seeking.