I was discussing with a colleague about the benefits of retirement savings accounts. In Canada they are called RRSPs (Registered Retirement Saving Plan) while in the U.S. they are called IRAs (Individual Retirement Account). He did not think they were useful, his reasoning being that once you withdrew the money out you were going to be taxed. If he saved $10,000 then he knew he was going to have the $10,000 plus whatever else he gained, the money would not be subject to any taxes. He’s right, but only partly.
The benefits of RRSPs are two fold:
1) The government allows you to reduce your taxes payable in the year you contribute.
2) The interest, dividends, or capital gains you earn on that invested money is not taxed.
The 1st point is an immediate benefit. Its like instant gratification for saving for the future. The 2nd point is an even more powerful benefit. It allows your money to grow and compound without being taxed. Let me illustrate:
Outside of an RRSP: If you invested $200 a month for 35 years, at a return of 8% and your tax rate was 35% then you would accumulate an amount of $237,715.29. You will not have to pay any additional taxes on your account since the Government has been taking it from you all along. You are paying 35% on the 8% return you are getting which basically reduces it to an effective return rate of 5.2%. See, this is where my colleague was only partly right. The taxes being paid each year would amount to $208,929.86 over the 35 years!
Inside of an RRSP: If you invested $200 a month for 35 years, at a return of 8% and your tax rate was 35% then you would accumulate an amount of $446,645.15. You would pay taxes on any amounts you withdraw from your RRSP. Assuming you were to withdraw it out at the taxable rate of 35% then you would pay $156,325.80 in taxes. The means by saving it an RRSP you save $52,604.06 just on the basis of tax-free compounding.
When you factor in the additional $29,400 in taxes savings you get back immediately because RRSPs are tax-deductible, then the benefits of RRSPs are even greater with $82,004.06 being saved! Saving money is a good step. Saving money in a RRSP is an even better step.
To calculate the long term benefits of RRSPs see KJE’s Financial Calculator.
Please note that RRSPs are not always the best option as it supports the higher income earners far more than low income earners. Please see Richard Shillington’s excellent Retirement Planning For The Rest of Us. A retirement guide for people of more modest income.