Tax Season and RRSPs

Please note that I am not a financial expert, just a person who has taken some time to learn about her taxes and therefore please consult your accountant or financial advisor before changing your investment strategy!
 
I finally did my taxes this weekend! I know, I left it to the last minute (in Canada we have until April 30th to file our taxes). I left it pretty late because I had some issues with my T4 that my employer needed to fix and it just took awhile to get done. I always do my own taxes using TurboTax (my dad buys the software every year and my family all uses it to file). It really isn't hard with the software- it walks you through it step by step with explanations. I also file everything related to taxes in a special folder so when it comes time to do them, I just need to grab my folder and everything I need is in there.

Anyway, the good news is that I am getting a refund! Yay!

I am not too savvy with taxes and deductible and credits etc but I noticed a lot of my friends don't seem to get some of the basic components of their income and taxes so I thought maybe I would do a post about some very basic info for any new filers out there or perhaps people in their twenties who have gone from annual refunds to actually owing taxes and they are shocked.

The one thing people don't understand is that a tax refund is not free money. When you get a refund it usually means that the government has overtaxed you throughout the year and is actually giving you back your own money. So yes, it is a nice surprise to get one, but it also means the government has been holding onto your cash for a year, when you could have been investing it! When you owe taxes, it means that the government didn't tax you enough and is asking for their own money back. If they had taxed you properly, you would have lost a bit more money each paycheque. However, unless you are self-employed and expect to owe income taxes, it does kind of suck to see that you owe.

The main confusion I get from people is that I always seem to get a refund, while my friends started owning taxes in recent years. The only explanation I can give for this is that I have RRSPs. RRSPs are tax deductible, which simply means you can deduct them from your income. It is a simple concept, but it can be a bit confusing if you aren't familiar with how they work.

Ok, let's say Joe makes $50,000 a year and his tax rate is 30% (this is arbitrary). Therefore Joe is left with $35,000 in cash and has given $15,000 to the government. Now Joe wants to save for retirement so he gives up a few vacations and designer shoes and manages to put away $10,000 into his RRSP. Come tax time, he tells the government about these RRSPs and they lower his taxable income by that $10,000. However, Joe has already paid tax on a $50,000 income, not $40,000! So the government refunds that tax he paid on the $10,000 to Joe ($10,000x30%) and he gets roughly a $3000 refund.

Now Joe knows that this $3000 is awesome, but he can't just go and book that trip to Australia quite so fast. That is because he will want to reinvest that $3000 in his RRSP, because he knows that he will be owning taxes on that RRSP one day! See, when you turn 71 you need need to turn that RRSP into a RRIF. That means you start taking an income on that money and the government will tax you on that income! An RRSP is not an excuse to not pay taxes, it is a way to defer taxes until later in life. The assumption that RRSPs work on is that you are in a higher tax bracket now than you will be in retirement, so you save money on taxes now and hopefully get the benefits of a lower tax bracket when you are retired. That is why some people wait to open a RRSP until their income is higher- because contribution room carries forward if unused, they can save more on taxes at the height of their career.

I should note here that it is important to start saving young, whether you put it in an RRSP or not. Due to compound interest, you will have a lot more money at the end, even if you invest the same principal! As well, I should note that you will get penalized for taking money out of an RRSP so it's not great for saving beyond retirement (however you can take money out without penalty for a first time home purchase or education, but you have to pay it back). The reason you get penalized is because the government already paid you back the taxes on that income and they will want that money back.

Now a Tax Free Savings Account works a little differently- with this method of saving you don't defer taxes, you avoid them all together! That is why the government caps the amount to can put in this type of account at a lower amount (I believe right now it is $5,500 per year). So this can be a good savings method for someone in a lower tax bracket who wants to save their RRSP contribution room for when they earn a higher income.

Wow- this post turned out a lot longer than I expected and I didn't even get into tax credits or any other things! I just hope that this little talk helps some young people figure out how RRSPs work because no one ever sat me down and explained how they actually work.

Please leave some comments with your methods of saving for retirement or to add on to my quick RRSP coverage!