RRSP’s-The Need to Know Basics
Reader Question: I want to save for retirement. Where is the best place to save for this? I have been told NOT to use RRSP. Can you help?
Saving for retirement is a good thing and RRSP’s (Registered Retirement Savings Plans) are a popular tool for doing so.
I don’t know the client’s age or his/her income so this answer is predicated on the fact that the client has several months of income in an emergency fund. An emergency fund is a base component of proper planning and should be done before making any RRSP contributions.
Also, it assumes the client is making more than $40,000 in income per year, as incomes under $40,000 don’t benefit much from tax savings on RRSP contributions.
Below I will try to define some of the Basics of RRSP’s and also illustrate some of the long-term advantages.
When Did RRSP’s Begin?
RRSP’s first came into existence in 1957 as a government supported effort to help Canadians save for their retirement.
Types of RRSP’s
There are broadly speaking three main types of RRSP’s
- Individual RRSP-where the contribution is made in your name and held in your name.
- Spousal RRSP- The contribution is made by you, deducted by you, but held in the name of your spouse.
This strategy would be employed when you are the higher income earner now and likely in retirement. The payout would be taxed in spouse’s hands and result in less tax payable.
- A Group RRSP-The contributions are payroll deducted and forwarded to the investment manager of the group RRSP and invested as per your directions in your individual account.
One key difference is that tax savings can be realized immediately if documented properly rather than waiting until the end of the tax year.
How Much Can I Invest?
You Can Invest 18% of prior years “earned income” minus any pension adjustments (P.A) up to a yearly maximum. Contributions made to a Pension Plan where you work, by you and your employer would be an example of a P.A. and would reduce your RRSP contribution amount. The maximum for 2012 is $23,280. This maximum will be indexed annually by the annual increase in the average wage.
Canada Revenue shows how much you can contribute annually on your Notice of Assessment.
What if I can’t contribute the maximum I am allowed?
Good news! The unused amount not claimed is carried forward and never lost. CRA keeps track and shows the unused amount that can be claimed in future years, either in whole or in part, on your Notice of Assessment and is not limited to 18% of your current income.
What Kind of Investments Can I have in my RRSP?
People often say I am going to buy an RRSP as if it were itself an investment. It is just a holding vehicle for certain types of investments.
Some of the most common types are:
- Guaranteed Investment Certificates (GIC’s)
- Savings Bonds
- Treasury Bills
- Mutual Funds
- ETFs (Exchange Traded Funds)
- Canadian Mortgages
- Income Trusts
The type you choose for your RRSP depends upon many things. One should consider your level of risk, your investment time horizon and the return you might require to achieve your financial objectives for retirement.
A good planner can help you build a retirement plan for you and answer these questions and help decide the right investments for you.
The Main Advantages of RRSP’s
- Contributions are tax deductible, resulting in less current taxable income
- Investment earnings grow on a tax deferred basis
How important is the tax deferral aspect of RRSP’s?
To see how important it is let us compare a 35 year old saving $7,000 per year into an RRSP versus the same $7,000 being saved in a taxable investment and being taxed annually at 40%, both investments earning 7%.
After 30 years the Registered Investment has a value of $707,511. The non-registered investment is worth $423,022. Every year the non-registered investment was worth less, as 40% of the investment earnings were lost to taxes.
Granted the registered investment has had zero taxation in the accumulation period, this is the real magic of tax -sheltered growth, and will be subject to taxes when income is withdrawn. Usually in retirement most Canadians will be in a lower tax bracket than during their peak earning years and the income will be taxed at a lower tax rate.
Even if we assume the client took the money in 1 lump sum at 65, not likely or recommended, and paid tax at 40%, the net after taxes would be $424,507, effectively the same as the non-registered plan.
What if the Investor Reinvested their Tax Savings every year?
This has a profound impact on the size of your accumulation! The tax savings on a $7,000 deposit produces an annual refund of $2,800 ($7,000 times 40%). If this were invested outside an RRSP it would produce an additional $169,209 of capital. The combined capital total at 65 would be $876,720.
All investors should seriously think about reinvesting the tax savings to magnify the accumulation.
The Benefits of Starting Early
If the client waits five years to begin investing and starts at 40 versus 35, he/she will accumulate only $598,567 (assuming he/she reinvests tax saving). A significant difference and proves the old axiom that starting early has significant advantages.
Your RRSP is Not an Emergency Fund
Yes, investors can withdraw funds from their RRSP and sometimes do, but seriously the consequences are more severe than you might imagine.
If you withdraw there is a withholding tax levied and is based upon the size of the withdrawal. This is applied to income tax owing, as the withdrawal is 100% added to other income in the year of withdrawal
|Withholding Tax Rates on Withdrawals|
|0 to $5000||
|$5,001 to $15,000||
|$15,000 and over||
The real cost is the long-term cost.
A male age 35, investing 7,000 per year at 7%, and wanting to retire at age 65 and currently has $50,000 of accrued RRSP savings. After 10 years he withdraws $25,000 to deal with a critical illness. What impact will this have on his future savings?
Impact of a withdrawal from RRSP Withdrawal Calculator The result is very significant as you can see.
To answer the final piece of this investor’s question where he/she has been advised not to use RRSP’s. I find there are few circumstances where an RRSP doesn’t make sense.
However low-income Canadians, or Canadians with expensive debt, or those without an emergency fund would be advised to tackle debt first, build an emergency fund, before investing in an RRSP.
This is not a comprehensive overview of RRSP’s but focuses on the Need to Know information. Every attempt has been made to be accurate but Errors and Omissions are Excepted (E&OE)
Now that your literacy has improved the next step is to find an advisor to help you begin the process of retirement planning.
Do you have RRSP’s and how old were you when you started to invest? – Mr.CBB
About Gary Gorr
I am an investment advisor employing behavioral finance principles in my advice giving and a licensed life insurance broker with 36 years of experience helping Canadians achieve financial security. CONTACT INFORMATION: (905) 202-8430 ext.626 firstname.lastname@example.org
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