RRSP 101: How it can help reduce your tax bill

Let's pretend the end of February is in sight. With the cut-off date for contributing to your RRSPs approaching, what are you doing to prepare?

A. Scrambling like a mad woman to gather funds and take out an RRSP loan.

B. Sitting in the Florida sunshine and relaxing. You have a plan that automatically invests money in your RRSP each month. Who's worrying?

C. Nothing. No money. No time.

It's amazing how many otherwise smart, savvy women wait until the last minute to invest or forgo investing in Registered Retirement Savings Plan at all. After all, the government is practically paying you to save your money and take control of your future!

An RRSP isn't an investment, per se, but a way to register your investments that shelters your money from taxes and allows those funds to grow tax-free until you withdraw them upon retirement. And don't forget the tax deduction. Depending on your tax bracket, you can save up to 40 percent on your taxes through your contribution. So, a $1000 contribution to your RRSP can reduce your tax bill by up to $400. What's not to love?

Virtually any and all investments can be housed under the RRSP umbrella today. That's the good news. There are a few words of a caution we need to mention, however, since some investment vehicles make better financial sense than others. For instance, stay away from annuities. They allow investment dollars to compound without being taxed — but isn't that what our RRSP does already? Why bother double-dipping in the same water hole? Besides, annuities carry higher annual operating expenses and reduce your earnings.

Limited partnerships are a bad bet too for many of the same reasons, plus it's often tough to get our money out of them come retirement.

So what sort of investments should you place under your RRSP umbrella? Again, that depends on how much risk you're wiling and able to take, your investing personality, the current economy , and when you need the cash. Here's a short chart outlining your popular choices, their level of risk, and whether they make it easy to get your money out when you need it.

Remember, although some of these options look like a good bet — they're less risky and their liquidity can't be beat — they can make for poor RRSP choices because their earnings are far too low. Some of them, such as savings accounts and money market funds, don't even keep up with inflation! Meanwhile, balanced mutual funds — particularly no-load funds that avoid paying costly commissions — offer a good middle-of-the-road option for those who want to diversity and who feel comfortable taking on some risk. Again, the younger you are and the longer time horizon you have, the more risk you can shoulder with a portfolio strong with equity (i.e., stocks or shares of a company, precious metals funds).

Whichever option you choose to invest in, there are a few RRSP rules that will help make the process easier and more lucrative in the long term.

Do it now

Yes, we're back at the main tenet of financial planning — make sure you put money aside for savings every month. That way, when RRSP season rolls around, you won't be clambering to find money to put away. Set up an automatic transfer to your RRSP on a monthly basis — whether it's $50 or $500, every little bit helps!

Max out

If you can, try to maximize your contribution — the limit for 2009 is the lesser of either 18 percent of your earned income or $21,000. Want to know what this year's contribution limit is? Check last year's notice of assessment — it's written there in black and white — or contact the CRA.

Pay it forward

If you don't max out your RRSP contribution this year, then the "deduction room" is carried forward to future years. Assume a taxpayer makes a contribution of $10,000 for 2009, even though her contribution limit is $21,000. The unused deduction "room" of $11,000 can be carried forward indefinitely and added to the calculation of the next year's deduction limit.

Leave it alone

No matter how tough times get, try not to dip into your RRSP savings. Not only will you probably pay whopping penalties, but when you withdraw that money, 100 percent of it will be taxable today. Ouch! Instead, focus on building up a reserve of cash in your portfolio to help you out on a rainy day. Ideally, it would be great to have enough to replace your income, if necessary, for at least six months, but three months is a good starting point.