Similarities between RRSPs and life insurance
RRSPs share several similarities, though most of these similarities are restricted to the investment portion of a permanent life insurance policy. The main similarity is that both offer tax-sheltered (or tax deferred) growth.
What is tax deferral?
Tax deferral refers to when your investments are taxed by the government. In a normal savings account, you’ll pay tax on your income, then deposit your after-tax cash into the account. You’ll also be required to pay tax on any earnings from that account (interest or dividends for example).
A tax-deferred savings account lets you claim any investments on your tax return, reducing your taxable income. The money in an RRSP or permanent life insurance account will be taxed on withdrawal, typically during retirement. Any returns on your investments in an RRSP or permanent life insurance account will also only be taxed on withdrawal.
This arrangement gives you more funds to invest with today, that you would otherwise have had to pay in tax. Those funds can then grow at a faster rate than the normal rate. When you do finally withdraw the funds, you may be paying a lower tax rate than you are today.
Note that the tax-deferred potential of both permanent life insurance and RRSPs are subject to annual limits.
Who benefits most from tax-deferred growth?
Anyone paying tax on their earnings can benefit from tax-deferred growth, provided they give their investments time to grow long-term. However, you will get more from tax deferral if you are earning more money, and paying a higher amount of tax each year.
For example, assume Person A earns $200,000 a year, and invests $10,000 in an RRSP. Their tax rate will be high – let’s say 50%. Their $10,000 reduces their taxable income to $190,000, which results in a saving of $5,000.
If Person B earns just $45,000 a year, their highest tax rate will be around 15%. Say they were able to invest $10,000 in their RRSP – they would reduce their taxable income to $35,000. This would result in a tax saving of just $1,500.
Over time, this difference would compound to an even higher amount. Despite the equity issue here, the takeaway is to use any tax-deferred saving offering that you’re able to, to maximize your savings for retirement. Because RRSPs and permanent life insurance have separate annual limits, it’s often a good idea to have both. If you can max out your RRSP contributions, permanent life insurance gives you the opportunity to create even more tax-deferred value.