How The RRSP Can Help You Reach Financial Independence

Retirement is a relatively new concept for humans. For thousands of years people would contribute to their communities in whatever ways they could until they died. But not in this modern day and age.

In today’s society, the general retirement age is considered to be about 65. The expectation is that a person works for 45 years and then abruptly stops and does nothing until death. When a person retires, they are essentially financially independent because they no longer need to work for any income.

Just to be clear. Retirement and financial independence are two very difference concepts. Retirement is the act of stopping work all together. Financial independence is a state where one does not HAVE to work but continues to do so because of a sense of purpose.

People who are financially independent have the ability to leave toxic work situations and have the freedom to pursue goals that align with their values.

People want to contribute and feel valued. Whether they are getting paid for it or not.

Retirement is in a sense, financial independence. But the word retirement is often connected with being old.

Through a financial lens, Robert Kiyosaki calls retirement “a person’s biggest liability.”

And a liability in financial terms, drains money from your pocket. The longer you are retired or financially independent, the greater the liability. This is why you need to have adequate investments and assets to achieve financial independence.

While the Canadian government does provide support through the Canada Pension Plan (CPP) and Old Age Security (OAS), these programs are unlikely enough to comfortably live on.

I think of these supports as a bonus and don’t factor them into my financial independence numbers because I can’t control them. On top of that, you can’t start collecting CPP and OAS until you are at least 65 years old.

So, what other financial vehicles can a person use on their path to financial independence?

In the 1950s, the Canadian government started the Registered Retirement Savings Plan (RRSP) to allow Canadians to save for retirement.

The RRSP is a registered account with the Canadian Government. Other registered accounts include the TFSA, RESP, RRIF, and LIF. Registered accounts have contribution limits and grow without the drag from taxes.

The infographic above shows how RRSPs are just one part of your retirement or financial independence plan.

Who should contribute to an RRSP?

Your personal situation dictates whether or not you should contribute to an RRSP. If you earn less than $50,000/year, it’s probably best if you contribute to your TFSA and aim to max out your contributions. This in it self, is a challenging feat!

To get the most value from the RRSP, you want your tax rate from your working years to be higher than your tax rate when you are living off your investments.

In the infographic above, you can see that the tax rate during the working years is the same in the drawdown or financial independence years.

For example, if you invested $5000 into an RRSP and you have a tax rate of 20.05% and you withdraw the money in retirement in the same tax rate, then essentially the only benefit is that your investment grew tax free. In this case, it’s better to invest inside a TFSA because it’s more flexible.

How can the RRSP help you achieve financial independence?

The biggest benefit of the RRSP is that you defer paying income tax until you withdraw the money in retirement.

The government essentially loans you money to help you achieve financial independence.

But it’s not a refund. It’s a LOAN! A loan you have to pay back with interest. But here’s the kicker. You get decide what interest rate you pay.

In the example above, you can see the difference in the marginal tax rate between the working years and drawdown years. The larger the gap, the better.

The tax refund is not a prize for saving for your retirement. Even though that’s what many people think it is. That refund is a loan from the government and you will wind up paying it back with interest if you aren’t careful. Withdrawing from your RRSP is more complicated than contributing to it. But this post will only focus on the power of contributions.

During your full time working years, you will be in a higher marginal tax bracket compared to when you retire.

Let’s take a look at how RRSP contributions cause a tax refund.

Referencing the graphics above, so now, instead of paying income tax on $100,000, after a $10,000 RRSP contribution, you get taxed on $90,000. But you’ve already paid taxes on $100,000, so the government gives you back the tax you paid on that extra $10,000 in the form of a tax refund. This tax refund is the deferred tax. It’s on loan from the government until you start withdrawing from your RRSP account.

The true benefit of the RRSP isn’t that it grows tax free. It’s the deferred tax in the form of the refund and the opportunity to reinvest that refund into income producing assets.

This is the real magic behind the RRSP. The government is essentially loaning you money through a tax refund, interest free. The money can be spent on vacations, cars, and fancy dinners. Or it can be reinvested back into the RRSP account immediately.

To get the most out of the RRSP account, tax refunds need to be reinvested back into your RRSP or TFSA.

The tax refund is a loan that you will have to pay back when you withdraw your RRSPs.

This is a game and you need to know the rules to win. Referencing the infographic above, you want to stay in the loop and keep things flowing into your RRSP or TFSA.

To make the RRSP worth while. You need to reinvest your tax refund! This is something I used to never do.

Below is an example of the power of reinvesting a tax refund back into an RRSP account.

Year	Salary	Marginal Tax Rate	Contribution	Refund	RRSP Account	Gain(5%)	Interest
1	$80,000	30%	$8000	$2400	$8000	$8400	$400
2	$80,000	30%	$8000+$2400	$3120	$18,800	$19,740	$940
3	$80,000	30%	$8000+$3120	$3336	$30,860	$32,403	$1543
4	$80,000	30%	$8000+$3336	$3400	$43,739	$45,926	$2187
5	$80,000	30%	$8000+$3400	$3420	$57,326	$60,192	$2866
6	$80,000	30%	$8000+$3420	$3426	$71,612	$75,193	$3581
7	$80,000	30%	$8000+$3426	$3428	$86,619	$90,950	$4331
8	$80,000	30%	$8000+$3428	$3428	$102,378	$107,497	$5119
9	$80,000	30%	$8000+$3428	$3428	$119,177	$125,135	$5958
10	$80,000	30%	$8000+$3428	$3428	$136,563	$143,391	$6828
—-	——–	———-	$80,000	$32,814	$146,819	———	$33,753

In the table above, the person invested $8000/year into their RRSP. Every year, this person reinvests their ‘tax refund’ back into their RRSP. After ten years, $80,000 was contributed to the RRSP but the total value was $146,819. Of the account value, $32,814 was from the tax refund(loan) and $33,753 was the total interest at 5%.

Things to consider when Investing inside your RRSP Account

There are no shortage of investments options to put inside an RRSP account. The amount of choices can be overwhelming and cause decision paralysis. The best thing to do is just start.

• Invest in index funds or all in one ETFs (Ex. XEQT, VEQT, XGRO, VGRO, etc)

• Keep fees low (Management Expense Ratio (MER) and trading commissions)

• Decide on the percentages of equities vs. bonds based on your risk tolerance and life stage

• Diversify and rebalance regularly

• Avoid investing in individual stocks (can’t claim capital losses)

• Invest your tax refund back into your RRSP account

• Don’t withdraw money from your RRSP until you are in a much lower tax bracket

• From a tax view, it doesn’t matter which investments you have in your RRSP. Whether your account grows through dividends, interest payments, or capital appreciation, it grows without the drag of taxes until you begin to withdraw from it. Then it gets taxed as income at your marginal tax rate.

• *Note – CDN listed ETFs that hold US stocks are subject to U.S. withholding tax. Usually around 15%. To get around this, hold US ETFs in USD RRSP accounts. All international ETFs hold back withholding tax on dividends.

How much can you invest into an RRSP account?

The more money you make, the more you can contribute.

Thankfully, the CRA keeps track of everyone’s RRSP contribution room. This can be found on your notice of assessment for the previous tax year.

For example, if you earned $100 000 in 2018, you could contribute up to $18 000 into your RRSP in 2019. In addition to any earned contribution room from the previous tax year, you can also contribute any unused room from previous years.

In the example above, RRSP contribution room is earned every year. If no contributions are made in a specific tax year, the room carries over to be used in future years.

The maximum contribution room a person can earn in 2023 is $30,780. So that means for the 2023 tax year, a person making $171,000 can contribute 18% of their income to an RRSP. The maximum contribution increases every year by a small percentage.

You can build up your contribution room over a number of years and invest inside an RRSP when you are in a higher marginal tax bracket.

When you first start working and earning money on a T4, you will begin to earn RRSP room. When you are young, your income will likely be at the low end of your lifetime income. As such, it would be better to invest inside your TFSA when your marginal tax rate is low. This way RRSP room can be built up and used when income is higher.

Where to invest?

What Should You Do With Your Tax Refund?

It might feel that you’ve received a windfall of cash when your receive your tax refund. Depending on your marginal tax rate and income level, your refund can be quite large. But remember, that money is on LOAN from the government.

That’s what is means when the tax is deferred. The government will eventually get the tax money back when you withdraw from your RRSP.

The best thing you can do with your tax refund is to reinvest it into your RRSP account. This allows your RRSP account to grow quickly and it becomes easier to max out your contribution room.

And remember, you don’t get that contribution room back when you make a withdrawal from your RRSP. Once it’s gone, it’s gone forever. The only way to get it back is to earn more through work.

What not to do in your RRSP

• Do not hoard your RRSPs as you get older. When you die, the government will take half (marginal tax rate).

• Do not invest in risky penny stocks or attempt stock picking. In registered accounts, you can’t deduct losses.

• Do not withdraw money early in a higher tax bracket.

• Do not day trade inside your RRSP. Keep commission fees low.

• Do not take money out of your RRSP to go on vacation, buy new cars, or renovate your house. You don’t get this contribution room back. Once it’s gone, you have to earn more room by working. Come tax time, you may get a refund or have to pay more tax depending on your marginal tax rate.

And if you die with money in your RRSP that is money you’ve essentially wasted because you worked for that money and weren’t able to reap the benefits. Depending on the amount of money in your RRSP, your dependents may receive less than half of the value.

Conclusion and Next Steps

Do your best to contribute as much as you can towards your RRSP and TFSA accounts. Both these accounts will be significant sources of income when you start withdrawing money to live off in your FI years. When you contribute to your RRSP, you need to reinvest the refund to get the maximum benefit from this registered account. Good luck out there and stay the course!