An important thing to understand about RRSP‘s is the concept of Tax Deferral. What does this mean?
Tax Deferral–This simply means that you will not have to pay tax on the money that your money makes for you until later when you need it.
Don’t worry I will make a little more sense of this.
We all understand that we have to pay income tax ( unfortunately)…
What we may not all understand is that when we invest and earn returns on our investments we also have to pay tax on the returns we have earned.
Let’s say for simple sakes that you make $50,000 and you pay 20% tax.
That means that on your income in the year you would have to pay $10,000 in tax (20% of $50,000)
On top of that for lets say you had $20,000 in some investment and earned a great return of 50%.
You would have made another $10,000 (20k x 50%) this year outside of your job.
Although it should make sense that we earned that extra money on our own and shouldn’t have to pay tax on it, that is not the case.
In this case you would have to pay full 20% on that investment earnings. An extra $2000.
So that means that you really only get to make $8000 even though you should get $10,000.
Sooo… What I am getting at here is….When you invest inside an RRSP you don’t have to pay any tax on your investment earnings until later (Defering it).
In fact you don’t pay tax on anything until you take it out.
One of the big benefits of this is that your money will grow year over year compounding on top of the money you earned prior years, tax free.
Tax will not erode the compounding effect of your money.
Tax can take a HUGE cut out of investment earnings, especially over time. The RRSP helps eliminate this effect.
The scary thing is that I used relatively low numbers here. Many people pay more than 20% tax and some pay up to 48% of what they earn in a year to the Tax Man.
To see the difference for your self, try out this calculator.
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