RRSPs explained for Americans

Canada has a retirement savings vehicle called the Registered Retirement Savings Plan, (i.e. the RRSP). Money that is put into an RRSP is not taxed until you take it out, sometime after retirement. This isn't just pre-tax income: money that you put into an RRSP is actually not considered to exist for tax purposes.

So let's assume that Alice earns $100,000 a year and is taxed at a flat 10%1. Her employer withholds this money and sends it to Revenue Canada:

Earned          = $100,000
Tax             = $100,000/10 = $10,000

But during the year, Alice puts $10000 into an RRSP. When it comes time to compute her actual taxes for that year, the contribution is subtracted from her earned taxes, so as far as Revenue Canada is concerned, her tax status is:

Earned          = $90,000
Tax             = $90,000/10 = $9,000
Witheld         = $10,000
Refund          = $1,000

Because her employer has witheld too much taxes, she gets the rest back.

And this is where things get interesting. Alice, wanting to maximize her retirement savings, decides to also contribute the tax refund. She does this by borrowing2 $1,000 and contributing it before the end of the current year3. So now her taxes look like this:

Earned          = $89,000
Tax             = $89,000/10 = $8,900
Witheld         = $10,000
Refund          = $1,100

The extra $1,000 reduces her taxable income to $89,000 which adds another $100 to the refund. So she borrows another4 $100:

Earned          = $88,900
Tax             = $88,900/10 = $8890
Witheld         = $10,000
Refund          = $1,110

Which adds $10 to the refund. So she borrows another $10 to put in the RRSP:

Earned          = $88,990
Tax             = $88,990/10 = $8899
Witheld         = $10,000
Refund          = $1,111

At which point it's not really worth continuing. But the important thing is that she managed to get another $111 for free5.

And in real life where the tax rate is a lot higher than 10%, you'll also get correspondingly more bonus money, which is why this is a thing.

  1. The real tax rate is higher and more complicated; 10% keeps it simple without detracting from my main point. 

  2. The loan itself costs money, but it's pretty cheap. It lasts a couple of months and has the RRSP as collateral. 

  3. Actually, the deadline's the end of February of the following year. 

  4. More precisely, figures this all out in advance and adds it to the current loan. 

  5. Minus the cost of the loan, of course. 

#   Posted 2017-09-10 20:20:16 UTC; last changed 2017-09-10 21:44:18 UTC