The RRSP advantage

So many Canadians don’t really understand how RRSPs work.

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From the February/March 2014 issue of the magazine.

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Financial planner Jason Heath is used to hearing from people who think an RRSP is a type of investment. “People say, ‘I don’t want to buy any RRSPs this year because I’m worried about the stock market.’” Whatthey don’t understand is RRSPs are simply a type of account: they can hold a long list of investments, from stocks, bonds and GICs to mutual funds and ETFs. Your RRSP holdings can be as conservative as cash, or as risky as penny stocks. So whatever your view of the market, it’s always a good time to contribute to your RRSP.

Misunderstandings like these, Heath says, cause many Canadians to make poor decisions with their RRSPs.But these retirement accounts have at least two benefits no investor should overlook: the tax refund when you make a contribution, and tax-deferred growth for as long as the money remains in the account. Given that a shrinking number of Canadians have employer-sponsored pension plans, RRSPs will provide thefoundation for many people’s retirement savings.

So getting an account started, even if your budget only allows you to contribute $50 per month, should be a priority for most.

If you’ve put off opening an RRSP, the good news is unused contribution room is carried forward. So if you recently got a raise, an inheritance or other new source of income, you may be able to make up for lost time. But even if a big windfall isn’t on the horizon, there are other ways to build up your savings more quickly. Let us show you how to use your RRSP to meet your retirement goals.


(Photograph by Raina + Wilson; Makeup and hair by Natalie Ventola / Plutino Group; Bike pump provided by Duke’s Cycle, Toronto)

Less taxes, more savings

Janet McCauley has never contributed to an RRSP and is starting to wonder if she should. “I know everyone does and they think I’m nuts for not doing it,” says the 41-year-old from Taber, Alta. “Why is it so wonderful to invest in RRSPs?”

What makes RRSPs so attractive is they allow you to defer tax on up to 18% of your previous year’s income—to a maximum of $23,820 for the 2013 tax year. (Your contribution room is reduced if you’re paying into a pension plan or deferred profit sharing plan through your employer.) The money in your RRSP will eventually be taxed when you withdraw it, but because most people will earn less income in their post-working years than while actively employed, those withdrawals should end up being taxed at a lower rate.

“I can’t tell you how many people don’t realize the taxes you save when you finally withdraw in retirement,” says Dan Hallett, director of asset management at HighView Financial Group in Oakville, Ont. “It’s a substantial savings.” That’s especially true for those earning high incomes today. For example, an Ontario resident with a $95,000 salary in 2014 would receive a tax refund of about $2,170 on a $5,000 RRSP contribution. Meanwhile, a retiree earning less than $40,000 would pay barely $1,000 of income tax on a $5,000 RRSP withdrawal. If you’re in the highest tax bracket today, RRSPs are a no-brainer.

An RRSP’s other major benefit is it allows your contributions to grow tax-free. This means you don’t have to pay capital gains taxes when you sell stocks or funds at a profit, and you don’t have to pay tax on dividends or interest you receive in cash. You’ll be taxed only on income you withdraw from your RRSP.

Put your finances on autopilot

Younger investors who plan to be working for several decades can afford to fill their RRSPs with growth-oriented equities because they can ride out market dips. But even double-digit investment returns won’t do much good if you’re not putting money aside on a regular basis. The same can be said for older investors who have only 10 or 15 years to save for retirement: the amount you put in is far more important than your returns because you have far less compounding time.

In his new book, Stop Over-Thinking Your Money!, MoneySense contributing editor Preet Banerjee explains how many people make the mistake of being so concerned with finding the perfect investments that they ignore the importance of saving. “Put $200 per month into a high-interest savings account that pays a measly 1.5% and you’ll have almost $26,000 after 10 years,” Banerjee says. “Invest only $100 per month and you’ll need an annualized return of almost 14% to get a get a comparable outcome.”

One of the most effective ways to build up your RRSP is to set up automatic biweekly or monthly contributions based on a percentage of your paycheque (10% of net pay is a good target). Get that money into the RRSP before you have a chance to spend it and you’ll barely miss it. This strategy of “paying yourself first” not only establishes good savings habits: it also has the major benefit of dollar-cost averaging, says Jason Heath. By making contributions on a regular schedule, you buy more shares when prices are low and fewer when prices are high. “So many people make a big contribution in February before the RRSP deadline,” Heath says. That can put you at risk if markets happen to be peaking at that time: smaller, more frequent contributions smooth out that risk.

Another benefit of contributing throughout the year is the simple satisfaction of watching your money grow more steadily, says Dan Hallett. “People can get more motivated about savings by seeing how all that adds up.”

Should I invest in TFSAs instead?

Tax-Free Savings Accounts (TFSAs) are another great way to grow your investments tax-free. When are they more appropriate than RRSPs? That’s another question investors find confusing.

Take Kathy Bluff (we’ve changed her name), a 40-year-old in Surrey, B.C., who earns a gross income of $42,000. “After many years of sporadic employment, I realized it’s time to start saving,” says Bluff, who holds only about $9,500 in her RRSP and $3,000 in her TFSA. With no debt or dependents, she wants to start making contributions of $750 per month, but isn’t sure which tax-sheltered account to prioritize.

The key difference between the two accounts is when your contributions are taxed. Putting money in a TFSA earns no up-front tax refund: your contributions are made with after-tax dollars. But unlike RRSPs, withdrawals from TFSAs are not taxed as income: the government doesn’t get a single dime when you take the money out.

Another important difference is that withdrawals from a TFSA don’t have to be permanent. Whatever amount you take out this year increases your contribution room next year. This feature makes them ideal for young people with short-term savings goals like weddings or a down payment on a home. On the other hand, when you draw money from your RRSP (except through special programs such as the Home Buyers’ Plan) that contribution room is lost forever.

Jason Heath says low-income earners like Bluff are likely better off with a TFSA. The up-front tax refund they’d get from an RRSP would be relatively small anyway, and in retirement their tax rate may not be significantly lower than it is today. Income from an RRSP in retirement may also cause you to lose income-tested benefits like the Guaranteed Income Supplement (GIS). If you’re a young professional and expect a much larger salary later in your career, or you’re on track to have a lucrative pension, you might also consider prioritizing your TFSA. (For more on this topic, see, “The Savings Struggle”)

Keep in mind, however, that few people can predict what tax bracket they’ll be in by retirement. So for many people, using a mix of RRSPs and TFSAs is a good way to hedge that uncertainty. “Everyone’s financial situation is different,” says Preet Banerjee. “There are so many variables in determining which account is better that there is no clear winner—at least none that can be recommended for everybody.”

Don’t ignore debt

Before you make the RRSP-versus-TFSA decision, let’s be clear about something. If you have any high-interest debt, focus on that before making any contributions to your investment accounts. The long-term expected return on stocks may be 6% to 8% before taxes, but paying down credit cards or unsecured lines of credit gives you a tax-free, risk-free return equivalent to the debt’s interest rate, which could be as high as 28%.

When it comes to mortgages, though, the decision is less clear. Many people struggle with choosing to pay down their biggest debt or saving in an RRSP. Even though the average discounted rate for five-year fixed mortgages recently spiked up to 3.59%—up from 2.64% last spring—it’s still reasonable to believe you could earn a better return with your investments. But only by taking risk: no guaranteed investments pay that much.

In general, if you’re in a high tax bracket and have a low rate on a relatively small mortgage, an RRSP contribution will likely give you more bang for your buck. But for those with more modest salaries who are paying a bundle in mortgage interest, an annual prepayment is often the better choice.

Also, low interest rates may not be around much longer. Economists expect rates to increase by two percentage points within the next three years, while the Organization for Economic Co-operation and Development (OECD) recently called on the Bank of Canada to more than double short-term rates by 2015. “There may be some greater savings down the road if mortgage rates go up,” says Dan Hallett.

Make your refund count

Think twice before blowing your RRSP tax refund on the latest high-tech gadget. Many investors treat their refund like manna from heaven, but it’s simply the tax-deferred portion of your RRSP contribution; at least part of it will eventually have to be paid back to the government. “The more productive uses you can find for that refund the better,” says Talbot Stevens, author of a new book, The Smart Debt Coach.

One of the most effective ways to boost your RRSP is to reinvest your refund. That’s like pre-paying the taxes you’ll eventually incur in retirement. Take someone in a 30% tax bracket who invested $5,000 annually in an RRSP and reinvested the refunds every year for 10 years. Assuming 5% annual growth, that RRSP would be worth almost $90,000, compared to only $66,000 if the refund hadn’t been reinvested.

Using your refund to pay down debt is another effective strategy. For those who don’t have enough income to make extra mortgage payments and also save for retirement, it’s a great compromise.

Don’t miss savings opportunities

An easy way to boost your RRSP savings is to take advantage of wealth accumulation programs at work. Employers often match at least part of your contribution, or they’ll offer RRSPs with lower management fees than you might get from most investment firms. Employee stock purchase plans can also be set up inside an RRSP or TFSA.

Unfortunately, people miss out on these opportunities all the time, says Jason Heath. “Most companies offer at least one of these programs, but they don’t explain them to their employees. They offer the details in handbooks and think that’s enough, but it’s all Greek.”

In his previous job, Matthew Sylvain, a 41-year-old government employee in Toronto, was amazed how many of his peers didn’t take advantage of his company’s stock plan. Employees were allowed to invest up to 10% of their salary in company shares, and that was matched by up to 50%. “It was basically free money,” says Sylvain. “Who in their right mind would turn that down?”

If you can’t make sense of your employer’s RRSP benefits, talk to your company’s HR department, your financial adviser or your accountant.

What if I don’t have the money?

Borrowing money to make up for unused contribution RRSP room can be a good idea, but only if you’re disciplined. “Most financial planners agree that a top-up loan—one that can be paid back within a year—is a good idea,” says Talbot Stevens. “The commitment and the amount is small—often $4,000 or $5,000—and the intent going in is that you’re going to get rid of this loan ASAP.” To make this work, it’s crucial to use your tax refund to immediately pay down a portion of the top-up loan. “Don’t fall into the behavioural trap of spending your refund,” warns Stevens.

More controversial are “catch-up loans,” which might involve borrowing $20,000 to $40,000 from a bank and taking five to 10 years to pay back. These require even greater discipline, because the refund each year must go towards paying off the loan. Another major drawback is that with so much cash flow going toward the debt, your ability to borrow in case of an emergency is limited, says Jason Heath. Don’t be swayed by the tactics banks use to nudge you into these loans, he adds. “The more investments and debt you have with the banks, the more profitable it is for them.”

However, Dan Hallett isn’t a fan of RRSP loans. “The big problem, even with small loans of $5,000 to $10,000, is that it creates a cycle where you’re continually chipping away at debt through the year until it’s paid off just in time for the next RRSP season,” he says. “But if you can make the loan payments, why not just make the contributions directly to the RRSP in the first place? I’d prefer to see people just save a monthly amount.” Hallett will concede, however, that for some people the only way they’ll contribute is to take out a loan, and if that’s the case he’s fine with it. “It’s better to borrow to invest in your RRSP than borrow to invest in a 60-inch plasma TV.”

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