What does RRSP’s do? The most typical response to this question is that they defer taxes. Should you get that answer as well, then you’ve got it only half right! The part you may have overlooked may be more important to your future than you may realize!

So then, what does RRSP’s really do? The correct response is that they affect you in two ways:

Firstly: They do defer taxes.

Secondly: They also defer the tax calculation.

Your tax bracket plays a very important role in this discussion, and while many Canadians focus only on the tax bracket they are in today, the tax bracket that they will be in when they finally take the money out is of as much importance if not more.

What Tax bracket will you be in when you take this money out?

Let’s assume you are investing money in an RRSP. You probably thought doing so would save you taxes. You may have even received information from tax professionals that you will “save” taxes. The truth is that RRSP’s are not tax savings accounts at all, they are tax deferred savings accounts. That means that you will eventually have to pay the tax.

The pressing question is at what bracket?

If you take the money out when you are in a lower tax bracket from the tax bracket you were when you have put the money in—you win. You saved taxes, but there’s no way of knowing that today.

If you have to take the money out when you are in a higher tax bracket—you lose.

An interesting thought: At the time of “withdrawal”, the Revenue Agency is not going to ask you what was your tax bracket at the time of your contribution; their only concern is at what bracket you are at the time of “withdrawal”.

what will be your tax bracket during retirement? Higher or Lower? Perhaps the same?

Let’s say you wanted to borrow $10,000. You would ask two questions from the lender before you took the money.

1: The first question would be, “how much interest do I have to pay”?

2: The second question would be, “when do I have to pay it back”?

If the lender responded by saying, “Right now we have enough money and don’t demand any payments from you at present, but there will come a time however, when we will need to be reimbursed. At that particular time, we will know exactly how much we need, and only then we’ll be able to determine exactly how much interest we have to charge you to get the required amount”.

Would you cash that check?

Absolutely not; but this is exactly what is being done with RRSP’s.
Keep in mind that the government is not saying you do not owe the tax. They are simply saying you can pay the tax later. At what bracket? That is a good question!

By knowing this, you may realize that it’s impossible for anyone to calculate how much money you will “save” by making a contribution today to an RRSP. It is impossible precisely because you have no idea in what tax bracket you will be at the time of withdrawal.

Let’s Assume that you are now in a 30% tax bracket and you wish to make a contribution of $10,000 to your RRSP. The best assessment of how much the “apparent tax benefit” of making a $10,000 contribution today, would be $3,000.

What many fail to realize is the fact that the $3,000 you “saved” in taxes today will be due with interest in the future. You wrote the check for $10,000 to the plan but you only have $7,000 in the plan. The government has their share ($3,000) in the plan as well. Had you claimed the $10,000 in income you would have paid your tax of $3,000 and received the balance of $7,000.

Just because the government allows you to defer the tax doesn’t mean that you saved the tax. In reality you have not saved any tax at all! You simply did not have to pay it today. The money you think you are saving is actually in your RRSP. They understand opportunity cost as well! They will want their $3,000 back one day with interest. Your share earned interest and so did theirs.

If the account value grew to $1,000,000 your share would be $700,000 and the governments share would be $300,000 assuming a 30% tax bracket.

Should they decide they want more and taxes go up when you start taking the money out, your share goes down.

If you listen to the wisdom of many accountants you will hear that deferring your taxes is a good thing because when you retire you will be in a lower tax bracket. They are not necessarily wrong because many people do retire in a lower tax bracket. The reason is not that taxes are less during their retirement years but rather many Canadians are broke, they cannot afford to retire at the same level of income they were making while working. Sad but true.

While many people do retire in a lower bracket remember that you do not have to be one of the “many”.

Do not misunderstand what we are saying. We are not saying these plans are bad. We are simply helping you understand what they do.

These plans can be a great source for retirement savings and most people who have access to such plans should consider using them, especially if you are getting a company match.

If you are not getting a match what are you getting? Tax deferral? It is better than trying to accumulate money in a taxable environment but do not forget you will pay the tax.

There are many rules that you need to know about access to the money in these plans. For instance one of the rules are that you must start taking out the required minimum distribution at a certain age and pay taxes on it even if you don’t need the money at that time and even if you are in a higher tax bracket at the time and it is not in your best interest to do so. Who is helping you with the rules?

If your thoughts were challenged with this information we would recommend that you sit down with a financial services professional and allow him to help you gain a better understanding on what type of retirement plan fits best for you.

You should understand that with RRSP’s you are not necessarily saving taxes. You are simply deferring them and you will have to pay them at some future time with a tax bracket yet to be determined. Your tax bracket could be higher or lower at that time.

Here is an even more compelling reason to get together with someone who can help you with the rules.

What is your exit strategy? Is your plan to pay all the tax? If there were opportunities to avoid paying some of the taxes would you want to know how to do that?

Assume for a minute that you were an apple tree farmer and had to choose between two alternatives regarding the payment of your taxes.

1. You could pay taxes on the seeds that you plant, or
2. You could pay taxes on your harvest.

Which would you choose?

If you are like most people, you would choose to pay taxes on the seeds. After all, you can harvest apples from an apple tree year after year after year…so why pay taxes on all those apples if you had the chance to just pay taxes once on the few seeds you plant?

When saving for retirement, you have a similar decision to make:

1. You can pay your taxes now on the money you put into your retirement savings (which is like paying taxes on the seeds), or
2. You can pay taxes later…each time you pull money out during your retirement… (That’s like paying taxes on the harvest).

Which of those alternatives are better?

We hope this post made you realize that there is much more you need to know about these types of retirement plans.