Friday, October 15, 2004

Putting as much as you can in your RRSP, IRA or 401k plan

If you are already familiar with IRA/401k/RRSP plans, you will not learn much from this post. Otherwise, if your early retirement plans are serious, you should consider contributing as much as you can in an IRA (or 401k or RRSP) as the first major step of you ER plan.

I don't know much about fiscality related to IRA and 401k plans in the US. I know they are similar to canadian RRSP. I believe that for most people seeking ER, most of your savings should be put in these tax shelters, unless you already have reached the maximum contribution allowed. If you are a Canadian citizen, RRSP is a must, particularly for early retirers. This is likely to be true also for Americans with IRA (or 401k).

Let me explain why early retirers would benefit more than others from these saving plans.
Let us suppose that as of today, I earn $65 000 a year. In Canada, I'll pay about $18 000 in taxes (about half to the province, the other half to the federal government). In Canada, taxes are highly progressive. There are four tax brackets in Canada, three in Quebec. If I put aside $10 000 a year in my RRSP, the tax saved will be that of the highest tax backet. At $65 000 income, the tax bracket is 46% in Quebec (counting for both government taxes). That is, to put aside $10 000, you only need to invest $5400.

The idea behind a RRSP or IRA is that you are supposed to pay back the taxes when you withdraw the money at your retirement time. Money thus withdrawn from you plan is taxed as standard income. The magic, for early retirers, is that you will likely withdraw such a small amount that you will be taxed at a much lower bracket or not at all. For instance, if I withdraw $10 000 at retirement time (and suppose I have no other income), I will pay no tax at all in Canada. Not only have you gained the initial $4600 in tax reduction, but all incomes generated by your investments inside the RRSP are also tax-free.

Keep in mind that this is true only if you withdraw a small amount from the RRSP. If you follow "experts" advice and withdraw 80% or you pre-retirement income, you will not likely benefit as much from your RRSP. Only the tax-shelter (incomes inside the RRSP are only taxed at withdrawal time, thus delaying tax payments and allowing the nest egg to grow faster) benefit will then remain. I don't know for IRA and 401k plans, but there is a maximum contribution you can put in a RRSP. It is the smaller amount between 18% of your gross income and $14500.

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