An RRSP is like a tax-free container for investments, not an investment in itself. Most people believe they invest in an RRSP. However, an RRSP is just a tool provided by the Canadian Government to incent people to build up savings for retirement. It also has the side benefit of encouraging investments in Canadia stocks and bonds, thereby driving growth in the Canadian economy. Basically, the government allows every Canadian to put a dollar value of investments in their RRSP 'box' depending on their income. If you don't fill the box one year, that room created doesn't dissapear - it carries over to the next year. You're allowed to fill up this box with elegible investments (there used to be a cap on the % of foreign investments that could be held in an RRSP, but this was eliminated in 2005) until its full. RRSPs have three primary features to them:
- The investor receives a tax deduction based on the amount she contributed to the RRSP. She doesn't have to apply this tax deduction to her current year income - she can apply to future years if she believes she'll save more tax by doing so. This can be significant depending on how high your income is.
- The investments held in the RRSP are allowed to grow tax free until funds are withdrawn from the RRSP. That is, the income generated from interest or dividends is not taxed and neither are capital gains generated by selling stocks that have risen in price. This can have a very positive effect on investment returns.
- When withdrawing funds from an RRSP, the amount withdrawn is included in income in that tax year and the investor pays the appropriate tax rate based on her total income level. Most people require less income during retirement and are therefore in lower tax brackets during these years.
I've found a lot of commentary on the web indicating that it's not clear if it's worth putting your investments into an RRSP. Anyone that says this is wacko. Almost everyone that says this is missing some piece of the RRSP equation when calculating the benefits. For example, I've found more than one article that did not include the tax savings received from the RRSP tax deduction as a positive cash flow in the analysis. Here's a simple analysis of the difference between investment in an RRSP and not:
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