I’m trying to clarify how much tax is saved when I contribute to an RRSP. If I earn $100k at a tax rate of 40% and then contribute $5,000 to an RRSP, does that mean I’ll get a refund of $2,000? ($5,000 x 40% = $2,000) What if my 40% tax bracket starts at 100k, but below that I’m taxed at 35%, how does that work?
Your approach to the income tax calculations when contributing to your RRSP account will give you a good estimate of how much you’ll get back due to tax credits. If you want to get more precise, it helps to keep in mind funds contributed into your RRSP result in the income tax on that money being deferred until you withdraw cash from your RRSP.
Let’s look at an example. If you make $100k and you put $5,000 into your RRSP, that means the $5,000 is not treated as income for that year. It’s as though you made $95,000. Assuming you get taxed at 35% for all money earned under $100k, this means you’d owe $33,250. ($95,000 x 35% = $33,250)
From the point of view of calculating your income tax, it’s like you never made the $5,000 which was deposited into your RRSP.
The catch, with RRSP accounts, is you do end up paying income tax on the money you withdraw from your RRSP. When you take money out of the RRSP you pay income tax on the money as if it were income. Usually people take money out of their RRSP account when they do not have other forms of income, meaning they will be in a low tax bracket and not end up paying as much tax as they would when they were making a steady income.
For example, let’s say people who make under $50,000 pay a 25% income tax, people making between $50k and $100k pay 35%, and people making $100k and up pay 40% tax. These are just made up tax rates for the sake of example, not an accurate representation of income tax rates.
If you made $100k and were taxed at 40%, then you’d owe $40,000 in taxes.
If you contributed $5,000 into an RRSP, that would bring your taxable income down to $95k. You’d pay 35% tax on the $95k, or $33,250. You’ve effectively saved yourself $6,750 at this point.
After you retire and have no other income, you can take the $5,000 out of your RRSP account. Assuming the tax rate for people making under $50k is still 25%, then you’ll end up paying $1,250 ($5,000 x 25% = $1,250) on the money withdrawn. By using the RRSP you saved $6,750, then paid back $1,250 in income taxes, leaving you with a net benefit of $5,500.
Again, this is a simplified example which just makes up tax brackets and ignores how different levels of income fit into different brackets. It’s just an example to show why RRSPs are a popular approach to deferring income tax. Putting money into RRSPs when your income is high helps you avoid being taxed at a higher bracket. When you take money out, it’s typically when you’re in a low tax bracket and the “income” from your RRSP account is taxed at a lower rate.
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