I think most people know I am not a fan of the Registered Retirement Savings Plan (RRSP) season. Do you want to know why? Check out my blog post from last year, “The Insanity of RRSP Season”. The essence is that proper retirement planning should incorporate regular contributions throughout the year and not just during the glorified traditional sales period known as RRSP season. It’s the investment industry’s Christmas shopping season, so get ready for a marketing onslaught ahead of the March 1st contribution deadline.
The misinformation out there about RRSPs further amazes me so I thought our focus in this blog post would concentrate on some of the popular myths out there. It seems many people do not understand the mechanics of RRSPs, mostly relying on what they can learn on the internet or from the inconsistent advice from their financial institutions.
There is no doubt that RRSPs are a great idea. They were Ottawa’s first big incentive to encourage retirement savings, and they were smartly conceived to offer a psychological nudge. In the rush to make your registered retirement savings plan contribution some facts can get distorted.
One of the reasons people rush to make their RRSP contributions before the. deadline (March 1st for 2017) is because of the income tax refund they get in April. They think the refund is a windfall that makes them wealthier, which is one of the big myths about RRSP contributions. By giving you a tax refund, the Canada Revenue Agency (CRA) seems as though they’re giving you something for nothing so you have the money saved, plus the money back. But CRA isn’t so generous. Like that old TV commercial, it’s case of “pay me now or pay me later.” Here’s a closer look at more of the realities of an RRSP:
Reality #1: Most Canadians do not have an RRSP.
About 60% of us have opened an RRSP, but according to CRA, some 94% of the available room is unused. Higher-income earners tend to contribute most because they have more money to shelter and more tax to pay. One reason for the large amount of unused room is that young families make a shrewd choice between real estate and retirement. Since they don’t have the money for both, they opt for the house.
Reality #2: A tax refund from a RRSP contribution does not make you money.
One of the common misunderstandings out there is that the amount contributed to an RRSP makes you money because of the tax refund you receive. Not true. Here’s an example. Suppose you make a $1,000 contribution, you live in Ontario, make $75,000 a year, and have a 33% marginal tax rate. This would generate a refund of $330. Big, bang, boom you now seemingly have $1,330 for an investment of $1,000. But the refund you receive may be for the original tax paid on the money contributed, but it also represents tax that you now have to pay later, when you take the money out. Say that on the day you get your tax refund, you withdraw the $1,000 from the RRSP. Because you took $1,000 out of your RRSP, you must pay tax on it. When you file your tax return, you will end up paying $330 in tax, leaving the $670 plus the $330 refund. Truly, a wash, timing aside.
The only way you come out ahead is if your tax bracket is lower in retirement, when you take money out. In that case, you pay tax at a lower rate than you would today.
And as your nest egg grows inside the RRSP, so does your tax liability. If your RRSP doubles, so your tax bill, assuming no change to your tax rate. CRA can be patient, but it has a long memory. Even with a higher tax bill later, the smart thing to do with your refund is put it back into your RRSP. That lets time and the compounding power of interest work for you. In the above example, you really would get the $1,330 of value – the original $1,000 contributed, plus the $330 refund added in. Next year, you’ll get a tax break on that $330, or another $109 back if you’re in the same tax bracket.
Reality #3: Borrowing for an RRSP is not always a good idea.
Your Financial Institution will often encourage you to do this. One argument you might hear is that you can use the refund to help pay down the loan. That’s true, and in some cases loans work. But here are some other things to consider:
Why do you need the loan? Is it because you don’t have the cash? If so, that may mean you have other debts. Far better to pay them off first.
Are you really going to pay it off? If you have the cash but not the discipline, are you likely to repay the loan or just pile it on to your line of credit?
So for many people, borrowing for an RRSP is probably not a good idea. If you were disciplined throughout the year and made regular payments, you shouldn’t need to borrow money. If you weren’t disciplined, you not likely to repay the loan with your refund.
Reality #4: RRSP loans are not tax deductible.
You can deduct the interest expense of loans for non-registered investments, but not RRSPs. Even at today’s low interest rates, borrowing at let’s say 3%, means you have to earn at least that to break even. Who knows where markets will end this year. It’s been a slow start and it hurts to be paying off a loan for an investment that’s worth less than when you started.
Reality #5: RRSPs are not tax-free.
RRSPs are tax deferrals and there’s a huge difference. An exemption is forever. A deferral means you must pay tax at some point in the future. An RRSP is a temporary tax shelter that allows the plan holder to delay paying taxes on contributions until the money is withdrawn. RRSPs are popular because they allow savings to grow tax-free until the plan holder is in a lower tax bracket normally retirement.
Contributions can give you a tax refund of up to 40%, depending on your tax bracket. But many people forget that you repay the tax when you draw down the money. If you dip into your RRSP before you turn 71, here’s what to your withdrawal immediately when it happens. If you withdraw:
- $5,000 or less, you’ll pay a 10% withholding tax, so you get $4,500 in hand;
- more than $5,000 but less than $15,000, the tax withheld is 20%; and
- more than $15,000, the tax is 30%.
And more tax may be payable because the money counts as income in the year you withdraw it. In the year, you turn 71, your RRSP must be converted into a Registered Retirement Income Fund (RRIF) because the government wants you to start drawing income, setting minimum annual withdrawal limits starting at about 7% in the first year and rising to 20% a year at age 94 and beyond. That too, is considered income for tax purposes.
Reality #6: You should not always max out your RRSP contribution.
If you have a lot of debt at high rates of interest, it is a better idea to pay that off. Credit cards can carry annual rates of 20 to 28%, while you may earn 4 or 5% inside your RRSP. Or pay down your mortgage. At these low rates, a little reduces a lot of principle, cutting interest costs over time.
If the amount is too high, it could be taxed in a high bracket when it is withdrawn. If not enough is withdrawn plan holders are forced to make minimum withdrawals when they turn 71. Also, the government could claw back your Old Age Security benefits if your taxable income is too high. Claw-backs can be avoided by income splitting where taxable income is split with a lower-income spouse, or withdrawing from a Tax Free Savings Account (TFSA).
Reality #7: You should not always aim for the RRSP deadline.
Contributing by the deadline is not the best idea, though it’s better than nothing at all. Most people don’t have the full amount lying around, and those who contribute at the deadline also miss an entire year of tax-free growth. Try a payroll deduction instead. It’s easy and painless. Money you don’t see is money you don’t miss.
Reality #8: You do not have to invest your contribution by the RRSP deadline.
For 2016, as an example, you only must contribute by the deadline to be able to apply it to your 2016 taxes. You can park in cash and invest it later or use it for your 2017 taxes or beyond. You can invest in just about anything or keep it in cash for if you want.
Reality #9: You do not have to use your contribution in the year issued.
People are worried that they lose RRSP contribution room if they don’t maximize their contribution in the year made available. Your current year contribution is based on your prior year’s earned income as confirmed on Notice of Assessment. What people do not pay close enough attention to is their RRSP contribution room carried forward from prior years. The difference between the current year allowable amount and what you contribute can be used in later years. You can carry forward any extra contribution space that you do not use.
Reality #10: An RRSP is not a pension.
An RRSP is just a pile of money (hopefully a big one). That’s where the stress comes in for many people. You must manage it. A defined benefit pension plan gives you a monthly payment for life. You don’t have to worry about it. An RRSP must be invested in something to create the monthly payment.
Reality #11: RRSPs are not better than TFSAs.
There’s a strong argument for young investors to divert RRSP contributions to a TFSA until they are in their higher income years and the tax savings are bigger. As well, for young people who are saving for a home, a TFSA may be better. It’s easier to get at the money and the amount inside grows tax-free. For low-income earners, a TFSA may also be better, because the income in a TFSA isn’t counted for tax purposes and so doesn’t affect such things as the means-tested Guaranteed Income Supplement (GIS). For seniors, a TFSA may also a better place to shelter money.
In the end, an RRSP is a terrific way to save and can play a key role in your retirement planning. But as with all things to do with personal finance, one size doesn’t fit all. Sometimes other things come first. We’ll delve into that more in a future blog post about personal finance. A primer if you will.
One thing is clear. We need to first understand what a RRSP is and its mechanics. It is only one of the tools used in constructing a good Financial Life Plan. Like all aspects of a proper plan, they all need to work together, be oriented to your personal situation, and incorporate all your goals and objectives. This is where working with a trusted financial advisor makes sense and will add definitive value. Its one aspect of Keeping Life Current.
