Surprising truths about your RRSP

Unfortunately, much of what you’ve heard about RRSPs is just plain wrong



From the February/March 2013 issue of the magazine.


surprise_322It wasn’t that long ago that retirement planning seemed a lot more straightforward: open a Registered Retirement Savings Plan (RRSP), choose your asset allocation, make contributions and—hopefully—watch your money grow. But the simple truth is RRSPs haven’t always been right for everybody: they were just the most popular option for tax-sheltering some of your earnings.

Things radically changed in 2009, however, when Tax-Free Savings Accounts (TFSAs) appeared. In fact, for many Canadians a TFSA can be a better choice, particularly if your income is limited and you can afford to use only one of these tax-sheltered accounts. TFSA contribution room now sits at $36,500 for every Canadian who was at least 18 in 2009, or $73,000 for couples—a sizable amount of money.

Consider, too, that fewer people have employer-sponsored pensions to rely on in retirement. Old Age Security is also being phased in later, meaning future generations will receive less money from the government in their post-working years.

All of which means Canadians need to be more vigilant about their retirement planning. RRSPs remain the pillar of that plan for many people, and it’s now more important to ensure yours is working effectively. Here are three of MoneySense’s seven surprising truths about RRSPs. Many of them go against the conventional wisdom, but our experts say they’ll help you get the most from your retirement savings.

You’re not as rich as you think

“Everyone needs to appreciate that RRSPs are fully taxable,” says financial author Talbot Stevens. With an RRSP, you can defer taxes for years, or even decades. What many investors fail to remember, however, is that deferring taxes doesn’t mean avoiding them altogether.

“The financial industry has sort of led Canadian investors to this view that if you don’t want to pay taxes, then RRSPs are your answer,” says Stevens.

The fallout from of all this, adds CIBC managing director of tax and estate planning Jamie Golombek, “is you could really get into trouble later on thinking you have more money than you actually have.” For example, he says, take someone who is in a 40% tax bracket who has diligently saved and invested for many years, growing his RRSP to a tidy $1 million. If this investor’s tax bracket is unchanged in retirement, he should consider his portfolio to be worth only $600,000 after taxes. “You owe $400,000 to the Canada Revenue Agency,” Golombek points out. “You have to look at that very, very carefully.”

Assuming, however, that our investor will retire in a lower tax bracket—say, 30%—the actual value of his RRSP would be $700,000 after accounting for taxes. Therefore, by using an RRSP he has significantly lowered his overall tax liability by deferring payment until retirement. But he’s still on the hook for a large chunk of tax later on.

The bottom line is you can’t take your statements at face value and base your retirement plans on the idea that 100% of your RRSP balance belongs to you.

Spending your refund undermines the whole idea

Despite what many people think, an RRSP tax refund isn’t “free money.” It’s not a gift from the government, nor is it a reward for contributing to your plan, and it shouldn’t be treated that way. It’s actually your money: more precisely, it’s the tax-deferred portion of your RRSP investment that you’ll eventually have to pay to the government.

So if you’re anticipating a big, fat refund cheque at tax time and you’re already envisioning yourself sipping Mai Tais in the Caribbean, or seated in front a new 50-in. flat screen, erase those thoughts from your head. While it may be tempting to blow your refund on something fun, you really should reinvest it or use it to pay down debt, says Karin Mizgala, co-founder and CEO of Money Coaches Canada Inc. Otherwise you’re saving a lot less money for retirement than you think. Remember, when you draw down your RRSP you’re going to pay tax on your withdrawals. Reinvesting your tax refunds is a bit like prepaying those taxes.

Reinvesting your refund can also supercharge your RRSP savings, thanks to the magic of compounding. Let’s assume you regularly contribute $5,000 to your RRSP each year and your marginal tax rate is 30%. That means at tax time you’ll net refund of $1,500. If you reinvest that next year along with your usual $5,000, your RRSP contribution will be $6,500 for that year, netting you a refund of $1,950. Add that to your regular contribution the following year and it becomes $6,950, which gets you a refund of $2,085, and so on. After 10 years of reinvested tax refunds and 5% annual growth, your RRSP would be worth almost $90,000. If you got the same rate of return but never reinvested the refunds, it would be just over $66,000.

A bear market is the best time to catch up

If you’ve got extra RRSP room and plan to make a large contribution, it makes sense to wait until the markets are down, says Talbot Stevens. “It’s not only more profitable, it’s also less risky.”

From 1976 through 2012, calendar-year returns on Canadian stocks were negative more than one-quarter of the time. But when you look at the annual returns following those down years, they average about 19%. By contrast, the average annual return was only 11% after years when the markets were up.

Therefore, Stevens says, you should consider buying equities in your RRSP when prices are beaten down, and maybe even borrow some money to make a bigger contribution than normal. “And to drill down on that point a bit more,” he says, “the more the market is down, the more it makes sense to borrow a bigger amount and catch up on your RRSP.”

For instance, if you have unused RRSP contribution room and the market has recently declined—say, 10% off its peak for the year—it might be reasonable to borrow an extra $5,000 to add to your normal RRSP contribution of $5,000. “So you double up,” says Stevens.

But if the market is down 20% from its peak—the usual definition of a bear market—that’s when you might consider catching up with a loan of $20,000, $30,000, perhaps even more.

“It’s a very simple strategy,” says Stevens, who stresses this only works for people who hold much of their RRSP in equities. “It doesn’t require a lot of sophistication. It’s about the cyclical nature of the markets.”

The problem with such an undertaking, says Golombek, is it’s very hard to time the market. “Just because something is negative right now doesn’t mean it won’t be negative again next year,” he says. Contributing a lump sum to your RRSP when markets are down is also a lot more emotionally difficult than it sounds. Investors who loaded up on equities after the financial crisis of 2008–09 would have done extremely well, but few had the fortitude to do so.

This story was updated on Feb. 26, 2015.

17 comments on “Surprising truths about your RRSP

  1. Nice to see a discussion around the after-tax value of RRSP savings.
    It would also be nice to see a similar after-tax analysis to the question Canadians wrestle with every year – Should I contribute to my RRSP or pay down the mortgage?
    Usually the analysis and conclusion (typically supplied by financial institutions with a vested profit interest in the outcome) compares paying down one's mortgage with after-tax dollars to the before-tax savings in an RRSP. Definitely an Apples-to-Oranges comparison.
    When the comparison is made on an after-tax basis the average Canadian is much better off ignoring their RRSP until after they have paid off their mortgage. But this strategy would cost financial institutions tens of thousands in mortgage interest income and investment fees, per Canadian, each year.
    With our latest comparison calculator, we try to help Canadians arrive at an answer that best fits their financial circumstances, saving them tens of thousands of dollars in mortgage expenses and investment costs.
    Finding a calculator that makes can make this comparison on an after-tax basis was impossible and we could not understand why no one had created one before. That is until we saw the numbers and realized struggling to save in an RRSP, while still having a mortgage, is just too profitable for financial institutions.
    It would great is MoneySense could do the analysis, after-tax, for Canadians and help them to answer this nagging question – Should I contribute to my RRSP or pay down the mortgage?


    • This is how I am doing it. I paid off my first mortage fast in just under 9 years. I also made sure I always paid off my credit card full and have never paid a penny in interest. I am now saveing about 25 thousand a year towards retirement. I am a blue collar worker and I only make 28 an hour. I also used the banks money to take out a secure line of credit on my home and bought an investment property that I make a profit of 400.00 per month. This profit is after the bank gets there cut. I used my bank's money to make money kewl eh! I also have a dividend credit card I profit about 300.00 a year on. I also use my company gas card at places that give me rewards at the pump another 60 per month. The key to sucsess is pay as little as possible to your banks in interest. I now pay as much as possible towards TFSA and RRSP all the tax I defer I reinvest Remember no mortage,thats another 12,000.00 a year I reinvest I just pretend I still have a mortage and just invest instead. I only drive a car that I can afford and pay for in full remeber interest interest interest is our worst enimie.


  2. Perhaps better advice is not to contribute $5000 to the RRSP each year and then get a refund which will be invested back into the RRSP, but rather to contribute $5000 and fill out form T1213 – Request to Reduce Tax Deductions at Source and get the amount of tax deducted from your paycheque lowered. Then take that extra money and invest it or pay off loans.

    I see a tax refund as an interest free loan that you gave to the government. If you are good with money, then what you want is to owe tax at the end of year; an interest free loan the government paid you. If you are not so good with money, then perhaps the best is to be perfectly even and owe nothing and get nothing back (or at least very little).


  3. This is a well-written and well-balanced article. It bothers me when people think their TFSA account is their primary and only retirement account. Because (unless they're under the age of 20) there's no way it's going to ever be enough moola.
    I know a lot of people who use the "tax bracket" excuse to never contribute to their RRSPs. Hell, I want to eventually end up in the highest bracket 'cause that means I'm one rick sucka. Another misconception is that *all* the money gets taxed at the higher bracket.


    • Wouldn’t that depend on your TSFA contribution and investments? So far, 5500 a year contribution limit isn’t that bad. If you started at 30 and paid up the limit, after 40 years, you would have $1,447,380.52 (assuming, for example, a 6.58% yield on the CPD ETF). Since CPD pays out monthly dividends (currently 0.06/share, you could have the potential for a nice healthy, monthly, tax-free, withdrawal income.

      Or am I missing something?

      I have both a TSFA and RRSP, with zero debt, and am hitting my “peak” earning years so am able to hit limits of both per year. Garth Turner seems to suggest TFSA have become far superior to RRSP, with regard to taxation. I am still on the fence since RRSPs are a great way to invest in foreign stock/ETFs and avoid getting hit by withholding taxes.


    • Basically, anyone who doesn’t understand how tax brackets work (and there are a disturbingly large number of people who don’t) probably shouldn’t be handling their own finances.


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  5. Just a basic question:

    How is it possible to re-invest your tax refund the following year along with your regular contribution if there exists a contribution limit?

    Assuming that the $5000 in the above scenario is in fact the maximum allowable contribution.

    In other words, if you invest $6500 ($5000+$1500) the following year, is this not considered an over-contribution?


    • For the year 2015, the maximum RRSP contribution limit is $24,930. If you contributed the $6500 mentioned above, you would still have $18,430 of income you could contribute for the 2015 tax year.


      • To make a contribution of $24930 – your taxable income for the year would have been $138500 as the RRSP contribution room is 18% of income up to a maximum of $24930. Of course most people have carry forward room


      • RRSP contribution is also capped by income. So unless this hypothetical person is getting a major raise year after year, they will run into their contribution limit sooner rather than later.


    • Wouldn’t reinvesting your tax return cause it to be considered taxable income in the future? Maybe I have something wrong in this, but it seems like you’re losing money by putting a tax rebate (not income) into something that’s taxed on withdrawal. It would be like getting a tax rebate and saying ‘no wait, now tax my refund!’ Or am I completely off on this?


      • The purpose of reinvesting/investing into RRSP is that when you’re retired the amount of income you will earn is less then when you’re working. So, yes the withdrawal of RRSP is taxable but your tax bracket will lower. What you are doing is deferring your taxes for when you are making a lower income plus it’s benefing you with a tax break on your higher income until retirement. I hope this helps. If not let me know and I’ll try to explain clearer.


  6. I contribute to my RRSPs but I use my refund to invest in a TFSA. I don’t know about everyone else, but I am in my twenties (mid) and with the TFSA room every year it makes a lot of sense to use that as a retirement vehicle. I don’t really view an RRSP as my main retirement source of income, because there is a level of uncertainty, i.e. What will be my tax rate in 30 years? I more or less use the RRSP as a tax-planning tool.


  7. Indeed, one can only ”guesstimate” the after tax value of his RRSP. The further we are from retirement, the less precise our estimate will be. I would even go as far as saying that given the wide variation range (due to different tax brackets possibilities in the future), disciplined young investors who will most likely fructify their RRSPs should devise their asset allocation based on 2 separate portfolios, one for RRSP assets, and the other one for non-RRSP assets. This strategy puts portfolio risk at minimum; the trade-off though would be possibly less tax efficiency.


  8. Why is there never any talk about the insane fees that are leached from RSPS every year? Ive asked so many people and no one has a clue how much money the banks are taking at start up – over the years – at ash in.


  9. I got $250K in my RSP my bank only give me 1.8% interest how is possible ?


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