RRSPs have two major advantages:
• Tax-deferred contributions.
• Tax-sheltered growth.
If you contribute income to a RRSP, you don't have to pay tax on that money. For instance, say you make $75,000 per year. If you contribute $5,000 to a RRSP, you can deduct $5,000 from your taxable income for that year. You save the tax you would normally have had to pay on that $5,000.
Once you have money or investments inside a RRSP, they can earn profits for you without being taxed while inside a RRSP, interest, dividends, and capital gains you make on the money inside your plan aren't subject to any tax. All your profits can go back to work for you.
Why are RRSPs such a powerful tool for saving?
Once you add the power of tax-free compounding to tax-deferred contributions you have a real money-making machine. To show you just how powerful RRSPs are, let's compare the different outcomes of investing $5,000 of your income inside and outside a RRSP. Assume your income is $75,000, which puts you in the top-tax bracket.
Investing outside a RRSP
Suppose you wanted to invest $5,000 of your salary. If you didn't use a RRSP, you'd first have to pay tax of up to almost 50% (depending on your province of residence). That leaves you with $2,500 to invest.
You then invest the money in an equity Segregated (mutual) fund. Suppose your money is 100% in stocks, and you earn a 10% pre-tax profit, all of which is in capital gains. Capital gains are taxed at half your marginal tax rate, or 25%. Assume you sold your investment a year after you bought it, you would lose a quarter of your profits. This means that you really only made an after-tax return of 7.5%. If you continue to buy and sell investments in each year for 20 years, the original $2,500 investment would be worth almost $11,000.
Investing inside a RRSP
If you invested $5,000 of your salary in a RRSP, you would be ahead right off the start. You could put the full $5,000 to work, as it wouldn't be taxed.
Once inside your plan, any profits you make also aren't taxed. If you earn an average of 10% a year in the stock market, you would be able to enjoy a 10% average annual compound return. After twenty years you would have over $33,000. That's 3 times the savings you'd have investing outside a RRSP.
If you take the money out of your plan, it's taxed. But even assuming it's all taxed at the 50% marginal tax bracket, it would still be worth almo
The RRSP edge
Investing inside a RRSP is hands down the better option. First, using pre-tax dollars means you have more money working for you. Second, your savings grow faster because you can reinvest all your profits without paying tax.
In our example above, saving $5,000 of your salary in a RRSP means that after 20 years, you'll have 50% more saved up. Instead of the almost $11,000 you'd have if you hadn't used a RRSP, you would have nearly $17,000, or an extra $6,000!
• Segregated Funds, (not mutual funds), also have additonal advantages.
• Base Guarantee of 75% of principal, up to 100%
• Probate Tax Bypass.
• Death Benefit Guarantee 75% of principal up to 100%.
• Creditor Protection and more!
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