Reminder: RRSP contribution deadline is March 1, 2011.

While we have all heard of RRSPs, many wonder ‘what exactly are they, and what do they do?’

Registered Retirement Savings Plans allow individuals can set aside a portion of their earnings (their “contribution” amount) before they pay income taxes on that income. This is why RRSPs are called “tax-deferred” investments. You don’t pay any tax on the income you contribute to your RRSPs in the year you earn the income. It is just like telling the government you made less money than you did, saving that income for yourself, and the government is perfectly happy with it!

So why, exactly, is RRSP season a time of opportunity for Canadians? Well, there are a number of reasons, but the following are two in particular that we shall examine in turn: using your RRSP to reduce taxable income, and secondly using RRSP contributions to shift some nagging debt from the ‘bad debt’ column into the ‘good debt’ column.

First, using RRSP contributions to reduce taxable income: an individual who earned, for example, $100,000 in 2010 should be able to contribute up to $18,000 to their RRSP. If they do, this means that for the tax year 2010 they will pay income tax on $82,000 of earnings. So contributing to their RRSP will decrease their taxable earnings, and everyone would rather pay tax on $82,000 of income rather than the full $100,000. This works out to saving between $6,000 and $8,000 of immediate tax owing, depending upon the circumstances and province of residence.

The second way that contributing to your RRSP presents an opportunity is by reducing ‘bad debt.’ In this column, we’ve examined the high price that someone pays by carrying ‘bad debt’ such as credit card balances, or department-store-card balances. The interest rates on these cards are astronomical, preventing you from achieving your financial goals. How can RRSPs help?

RRSPs, as we saw above, will decrease income tax payable (again, everyone’s situation is different, but this is a general truism). Thus, the more you contribute to your RRSP, the larger your refund will be. If you do not have enough cash to fund a contribution, an RRSP loan could be used to fund your contribution, thereby generating an even larger refund.

This larger tax refund can then be used to pay down the RRSP loan you may have taken out; or it could be used to pay down those credit card balances. By doing this you will move that debt from the 18%+ range of interest, to something much more reasonable, say prime + 1 or 2%.

After examining these two situations one can see how RRSPs have played a central role in the retirement planning of Canadians for over half a century since their introduction.

Everyone’s situation is different. Please consult your local independent Certified Financial Planner® before taking any decision related to your family’s finances.