As mentioned earlier, tax-free growth is one of the biggest advantages of RRSP contributions. Here we show you just how powerful both tax-free contributions and tax-free compounding can be, by contrasting Joe, our RRSP contributor, to Jane, our RRSP non-contributor.
The examples below make several assumptions about Joe and Jane:
- Joe and Jane are both 21 years old and have recently graduated from university.
- The province in which they reside has a flat 10% tax rate that applies to everyone.
- Both of their incomes increase on a yearly basis.
- They each have a salary that starts at $24,000 at age 21 and grows to $180,000 by the time they are 69.
- Both Joe and Jane change 7.3% of their portfolio every year.
- Joe maxes out his RRSP contributions every year, while Jane invests the same amount in a non-RRSP account.
- We assume inflation of 3%, which raises Joe's RRSP contribution ceiling.
- Their portfolios consistently return 7.5% per year.
- Both Joe and Jane hold the same portfolios made up of 50% common stock, 16% preferred shares and 34% bonds and guaranteed investment certificates (GICs).
- They each receive a return of exactly 11% per year on their common stocks.
- They each receive a return of exactly 4% per year in capital appreciation, plus 3% of the value of their preferred shares in dividends.
- They each receive 4% interest on their bonds and GICs.
As you can see, the difference is staggering: Joe's income tax is significantly lower than Jane's. Contributing to an RRSP reduces tax liability not only because these contributions can be deducted from the contributor's earned income, but also because the returns on these investments are exempt from any capital gains tax.
We've charted the difference in size between Joe and Jane's portfolios.
As the graph shows, the difference between the two portfolios is huge. In fact, given the assumptions we've made, it amounts to more than $3 million! There's a very clear difference between the way money grows when it is sheltered from taxes and the way it grows when it is taxed every year. In an RRSP, the money that would have been spent on taxes is actually invested back into the portfolio, rather than being taken out of the portfolio and given to the government.
Don't get overwhelmed or distracted by the different assumptions made in these examples. The core idea you should take away from this section is simple - contributing to an RRSP benefits you in two ways: 1) it reduces the amount of income tax you must pay each year, and 2) it allows your investments to compound tax free (a huge advantage).