Wednesday, 20 January 2016

RRSPs for Millennials




In the 1st 60 days of any calendar year.  If you walk into any of the nation's financial institutions, you will for sure see posters and reminders of the upcoming RRSP season and how it is time to contribute.  If you use human tellers at the bank, odds are that they will mention this to you.  If you are an ATM person, no doubt there will flash a reminder on the screen of the upcoming RRSP deadline.

We will assume that for this article that you are in the millennial generation, that demographic bracket aged 18 to 34 years old.  Much media attention has been given that this particular generation has forego the classic bricks and mortar bank and gone online.  But in general, most Canadians will use a bank, it is most likely where your pay cheque will go.

That being said, since most pay cheques go to the bank, it makes it easy to setup your RRSP using a pre-authorized checking arrangement (PAC) - transferring funds directly from your main account into your chosen investment vehicle inside your RRSP.

But what exactly is an RRSP, you ask.  For starters, RRSP is an acronym that stands for registered retirement savings plan.  RRSPs were started in 1957 by Liberal Prime Minister Louis St. Laurent to encourage Canadians to save money for retirement.  People by nature, wanted to spend money as soon as they earned it.  Ottawa need to give an incentive to Canadians to save for the future.  That first year in 1957, the maximum you could contribute was only $2,500 or 10 percent of your taxable income, whichever was less.  Today it's the lesser of the $24,930 or 18% of taxable income.

An example with calculations would best show exactly what an RRSP does.  Say for example, you earned $40,000 in 2015, putting you in the lowest federal tax bracket of 15%.  Also for this example, assume that you are an Ontario resident, which means you will pay an additional 5.05% in provincial income tax.  Now comes the RRSP magic.  Also in this example, you will have contributed $5,000 before the RRSP deadline for 2015.

Now it is April and you need to file your income tax for the calendar year 2015.  That $5,000 is deducted straight from your taxable income.  So if your taxable income before the RRSP was $40,000 you can now tell the government your taxable income is now $35,000.  If you combine the federal and provincial income tax rates (15%+5.05%=20.05%), you'd get a refund of 20.05% of $5,000 which is $1,002.50

That is correct, Ottawa will send you a cheque for $1,002.50 if you contribute $5,000 to your RRRP in this example.  (The effect is more dramatic if you are in a higher tax bracket).  Where does this money come from you ask?  Basically your employer will tax you every 2 weeks using the $40,000 income.  Come tax filing time, you tell the government that the $40,000 was actually $35,000 so the taxes my employer deducted, some of it will need to be returned to me.  Viola refund.

Sounds pretty good to a young person, but remember Ottawa's generosity is reversed when you retire, as soon as you start taking money out of your RRSP, tax will come off.  But by that time, you will be in a lower tax bracket.  It's a fair trade off for all those years of working.

I suggest to the millennial reading this, that $1,000 cheque would best be used to fund next year's RRSP amount.  This way instead of paying $5,000 in RRSP contribution, you will only need to find $4,000.  This is compounding at it's basic.  Yes, there is the temptation to spend it on a new tv or something else but compounding it this way, just makes it easier to save and isn't that the intent of all of this.