When you’re talking about tax planning, the subject of RRSPs usually comes up. How much should I contribute to my RRSP this year? Can I take them out to make a big purchase? What’s the maximum amount I can put away? Before answering those questions, it’s a good idea to first understand what the point of an RRSP is and then explore how to use them effectively in tax planning.

The RRSP (Registered Retirement Savings Plan) was designed to help employees save for retirement. As an employee, unless you’ve got loads of medical bills (which hopefully you don’t) or you donate a ton to charity, there’s not a whole lot you can do to reduce your tax bill. Even if you manage to put some cash aside for savings, your investment income will be taxed each year in whatever tax bracket you fall. With so much of your income going to taxes, it makes it really difficult to save for retirement – or any big purchase for that matter.

Yet the tax system can seem particularly unfair if your income level fluctuates significantly each year. Suppose you work really hard one calendar year earning 100K and decide to take the next year off. When you go to file your taxes, you’ll pay approximately 24K for the year and no taxes the next one. On the other hand, say you earned the 100K starting in June – that income would be spread over 2 tax years and you’d pay approximately 6.5K of tax each year. That’s a total difference of 11K of tax dollars!

While self-employed individuals can prevent this situation by deferring income with a corporation, employees don’t have that luxury.

The RRSP is then the mechanism that gives employees some flexibility over smoothing out income.

The assumption is that when you retire, your income will drop significantly. Much like the example above, there should be a way to compensate for the fact that you earned a high wage over a number of years, but will suddenly earn much less in future.

When you contribute to your RRSP, that amount is deducted from your current year earnings. In our example, if you earned 100K that year but put 20K in your RRSP, you’d be taxed only on 80K. If you needed the 20K the following year, you could effectively take it out of your RRSP and it would be included in your income at that point. By doing so, you’ll pay a total tax of about 17K instead of 24K. Not bad for a little planning.

While the RRSP was designed for retirement planning, it doesn’t have to be used exclusively as such.

If your income fluctuates year over year or you’re an avid “4 hour work week” fan who likes to take extended vacations, you may be able to use the RRSP to take advantage of its income smoothing ability. If your income is high in one calendar year, the idea would be to maximize your RRSP contribution. Once your income dips the following year, you can take out funds from your RRSP and pay tax at a lower tax bracket.

There are certainly quite a number of other factors that affect whether or not RRSPs are right for you. You may be making a home purchase and want to learn about the Home Buyers’ Plan, you may have a spouse and want to make contributions on their behalf, or you may have an RRSP matching program at work and want to decide how best to take advantage of it.

Whatever your situation, the idea is the same – with an understanding of how the RRSP works– a little planning can go a long way.