Last week I talked about saving money by cutting down on thoughtless spending. As far as I know, there are really only two ways you can save money; cutting your variable spending or earning more money. This week I want to talk about what you can do with your money once you’ve started saving. This is a large topic, so it will likely be broken down over a few weeks, but I want to start with the topic of RRSP’s and how you should take advantage of them.
You no doubt have heard of RRSP’s, every January and February we’re bombarded with commercials for them. If you just watch the commercials, you would know that they involve retirement and banks, but not a whole lot more than that. Let’s start with the basics. RRSP stands for Registered Retirement Savings Plan. Let’s break that down a little. It’s Registered because the government knows about it, and it will effect your taxes. It’s designed by the government to encourage Canadians to save money for their retirement.
People often have the misconception that the RRSP is itself a product. It’s not, think of an RRSP as a folder that can hold many different types of investments. You could put many different types of investments into an RRSP. Cash, gold bars, GIC’s, Bonds, Mutual Funds, stocks and more are all allowed to be put into an RRSP. We’ll talk more about those different types of investments in the coming weeks.
You might be wondering why you would go through the bother of setting up an RRSP. RRSPs have several tax advantages:
First, your contributions to your RRSP are tax deductible. As an example, let’s say Peter is making $80,000 a year. Peter has saved up $10,000 and decides to put it into their RRSP. At tax time, it would appear that Peter has only earned $70,000, which means that he would pay less income tax than someone who earned $80,000. Paying less tax is a good thing, that’s more money that you could save for yourself.
An RRSP is basically a tax shelter. Ordinary people like us don’t have a lot of access to tax shelters, so we should take advantage of it whenever we can.
Second, while your money is in the RRSP, you pay no tax on it. Normally you have to pay tax on any money you earn through the year. If your bank account pays you interest, you have to pay tax. If you make money on a stock, you have to pay tax. You pay no tax on your investments while they’re in your RRSP. Over the years this can add up to a considerable sum.
Now, you will have to pay tax on your RRSP eventually. The good news is that when you start taking out your RRSP, you should be in retirement which will put you in a low tax bracket. This means when you start taking out money, you’ll have to pay less tax than if you took it out before you retired. When you get to your retirement age, you can transfer your RRSP to an RRIF (Registered Retirement Income Fund) which allows you to avoid more taxes. When you get into your 40s and 50s, you should talk with a financial planner to decide your RRSP exit strategy.
To review, these are the advantages to buying RRSPs:
- Tax deductible contributions
- Tax sheltered earnings
- Tax deferral
You can contribute a maximum of 18% of your earned income or $23,820, whichever is lower.
There are advantages of contributing to your spouse’s RRSP. Let’s say your spouse earns less money than you. You can contribute to a Spousal RRSP which would serve as a way to split your income. For example, you and your spouse have retired and you want to withdraw from your RRSP. You’d pay less tax if both of you withdrew $25,000 than if one spouse withdrew $50,000.
If you take money out of your RRSP before you retire, you will pay some taxes on it. First you’d pay a withholding tax, which can range from 10% to 30%. On top of that, the amount you take out is taxable income. Let’s say your earning $60,000 but an emergency has come up and so you take out $30,000 from your RRSP. First you’d pay a 30% withholding tax on the $30,000, so you’d only get $21,000. Then the $21,000 would be added to your $60,000 yearly income, so at tax time it would appear that you earned $81,000, which could push you into a higher tax bracket.
For these reasons, you might want to look at a TFSA, a Tax Free Savings Account, which we’ll look at next week.
There are two exceptions where you can take money out of an RRSP without paying a penalty, buying a house or going back to school. You do have to put the money back in, and there is a limit on how much you can take out.
After all of this, you may be wondering if it’s worth the bother. Here’s the thing, the rich have all this figured out. They have ways of hiding their money, putting it overseas, making the system work for them. Most Canadians don’t do this, they don’t save, they don’t contribute to their RRSP or any real savings.
Scotiabank did a survey and found that only 31% of people planned on making a RRSP contribution from 39% the year before. Bank of Montreal did a similar survey and found 43% planned to contribute, down from 50% the year before. The reason given? They can’t afford it.
To put in $2,000 a year would require putting aside $167 a month, or six bucks a day. That’s less than eating lunch at Subway every day, or drinking two lattes a day. Most VFX artists I know make a decent living, not rich by any stretch of the imagination, but enough to survive comfortably in Canada. This is something we all should be doing, even if it means cutting back on some conveniences.
If you have any questions, or if you have any corrections to make, please comment in the box below.