Ah…It’s that time of year that banks and investment firms will start the deluge of advertisements about RRSPs and how you must get your contributions in by March 1st. It’s also the time of year that I’m most irritated by the misinformation in these ads.
In today’s episode, I’m going to tell you why the pushing of the RRSP products are a problem and how to rethink RRSP’s strategically, maximizing your tax windfalls AND your long term savings.
One of my pet peeves as an advisor is when people ask if they should buy an RRSP.
Now, I’m not blaming any of my clients for asking, but rather, the financial industry as a whole for pushing RRSPs as a product so aggressively, while simultaneously failing to inform people how they really work.
As if it’s some kind of golden ticket… Unfortunately, it’s NOT that simple.
So what is an RRSP then if it’s not a solution to all things retirement? An RRSP, also called a Registered Retirement Savings Plan, is simply an investment account recognized by the government to have special tax treatment to encourage Canadians to save for retirement.
When you contribute to an RRSP, the amount you contribute is deducted from your income for tax purposes.
For example, if you earn $50,000 per year, after paying income tax of $8,500, you’re left with $41,500 to spend. However, if you could contribute $5,000 of that $41,500 to an RRSP, your taxes would look like this:
Earned Income: $50,000 $50,000
RRSP Deduction: $5,000 —-
Taxable Income: $45,000 $50,000
Tax: $7,000 $8,500 $1,500 saved on taxes!
Since your taxable income is $5,000 lower, you save about $1,500 in tax! However, don’t think of this as mad money. What you do with this extra $1,500 is important.
With the RRSP, you get to deduct that contribution from income now and any other subsequent contribution up until retirement. However, your withdrawals ARE taxed as regular income in the year of withdrawal. This is a good thing for most people, because you typically have less taxable income in retirement than you do while working, so your tax rate will probably be lower.
Now, if you only contribute the $5,000 and spend the $1,500 tax windfall, you remove the main benefit of the RRSP, which is being able to save more now than you would normally be able to.
To really maximize the benefit of an RRSP, you should determine how much you can contribute so that your spending level can stay the same.
Full Benefit
Earned Income: $50,000 $50,000 $50,000
RRSP Deduction: $7,000 $5,000 —–
Taxable Income: $43,000 $45,000 $50,000
Tax: $6,500 $7,000 $8,500
Total savings: $7,000 $5,000 $5,000
Over to spend: $36,500 $38,000 $36,500
Back to our example of the $50,000 earner, a contribution of $7,000 into the TFSA would reduce your taxes to just $6,500. If you save the initial $5,000 in a TFSA or taxable investment account, you’d be paying the extra $2,000 in taxes. Incorporating the tax benefits of the RRSP lets you save an additional $2,000 right now, while still letting you spend the exact same amount of money! If you only save the $5,000 in the RRSP and spend that tax windfall, you’re increasing your current spending to $38,000, but not getting the benefit of using the RRSP to be able to save more. The ability to save additional money, along with the tax-free growth within the account makes the RRSP a very useful vehicle for retirement savings.
Now that you know how to maximize an RRSP, there are some important rules to note with the RRSP account:
Every year after you file your taxes, your notice of assessment provides a chart that shows your available contribution room for the year. You can carry forward contribution room that you haven’t used in all previous years. You heard that right, if you haven’t contributed at all (or very much) since you started working (even including that part time summer job in high school), you can carry forward all the room you’ve earned since you started working.
Going back to the $50,000 earner, they would have accumulated RRSP room of $9,000 for the year. This maxes out at $26,010 for 2017 (or the equivalent of earning $144,500). Your old carryforward room is added to the new room earned in the previous year, and reduced by contributions you’ve made into the RRSP, and a Pension Adjustment if you have an employer pension plan. It’s important to check on your Notice of Assessment, or online using CRA’s MyAccount to make sure you don’t contribute more than you’re allowed and incur steep penalties.
Now as I mentioned, unfortunately reaching your retirement goals is not as simple as throwing money into an RRSP. You’ll probably need to invest the RRSP in something that will earn a higher return than simply an interest account.
Wait…you didn’t know that within an RRSP, you can invest in stocks, bonds, ETF’s and mutual funds? That’s right! That’s why all of the advertising about RRSP products are my pet peeve. It suggests that putting your money into an RRSP is the end game.
Of course, how you invest will depend on your investment style, your goals, and your individual risk preferences, but you should discuss that with your advisor.
As the name suggests, the RRSP is mainly for retirement savings. If you need to withdraw money before retirement, the withdrawal will be included in your income for tax purposes. We’ll cover all of the penalties and exception scenarios in future videos.
The RRSP can be a great tool for Canadians to save for retirement, but it’s just a part of a well thought-out plan and there are several tax-implicating tools out there. Speaking of which, in my next video, I’ll discuss which is better for your situation, the TFSA or the RRSP.
There is also withholding tax taken off automatically before you receive the withdrawal. For example, if you need to withdraw $10,000, withholding tax of 20% would be applied, meaning you’d only receive $8,000. A $50,000 earner has a marginal tax rate of 31.15%, so total tax on the withdrawal would be $3,115. Since $2,000 was withheld by the financial institution, you’d owe an additional $1,115 come tax time. Not something you want to be sprung with, especially if the $10K withdrawal was due to an emergency. And to add insult to injury, you don’t get that $10,000 room back in the future. On the bright side, this can be a really good behavioural stop to prevent people from raiding their retirement savings.
There are a couple of exceptions to this though. If you’re going to school, you can use the Lifelong Learning Plan to withdraw up to $20,000 total (up to a maximum of $10,000 per year). If you’re buying your first home, you can take out a maximum of $25,000 to put towards a down payment. You have to repay these amounts within a set period of time.
You can learn more about these plan in the links below.
Additional Resources:
http://www.cra-arc.gc.ca/esrvc-srvce/tx/ndvdls/myccnt/menu-eng.html
http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/rrsp-reer/menu-eng.html
