Retirement: It’s nice to get out of the rat race, but you have to learn to get along with less cheese.

~ Gene Perret

Update: This article is featured in the Money Hackers Carnival #108 – Dare or Truth! at Eliminate the Muda. Thanks. I love that theme!

It’s also included in the Carnival of Financial Planning  Edition #133 by The Skilled Investor. Thank you!

I’ve had a lot of inquiries about this lately, so I thought I would address it today. I’ve written about RRSP Basics and RRSPs vs. Paying Down Debt, but these articles dealt mainly with general issues and new contribution money. I haven’t directly addressed the question of whether or not you should actually withdraw money from existing RRSPs in order to pay down credit card or mortgage debt.

Most financial advisors would consider it blasphemous to even entertain the idea of taking money out of your RRSPs. Now this might have something to do with the fact that their assets under management and resulting commissions would take a hit, but there are some very good reasons to leave your retirement savings alone:

• Once you retire, either because you want to or are forced to do so for health reasons, it will be a lot harder to earn more income to support your lifestyle.
• If you’ve managed to save some money so far, pat yourself on the back and leave it alone. Who’s to say you’ll be able to save as much in the future? A bird in hand . . .
• You will have to pay taxes at your marginal rate on the money you withdraw. (See RRSPs: Taking Money Out for a rundown on withholding taxes.)
• You will lose the RRSP contribution room for the amount you withdraw.

Situations Where You Might Consider RRSP Withdrawals to Pay Down Debt

Having provided the above caveats, I can think of a few situations where it might be worth your while to at least look at the math. There are quite a few variables here, so there’s no one size fits all solution. If all else fails, remember the Cardinal Rule of RRSPs: they work best if your marginal tax rate is greater at the time you put the money in than when you take it out. Here are some factors that might lead you to consider an RRSP withdrawal:

1. Significant Increase or Decrease in Your Current Income

Perhaps you are a commission salesperson or self-employed individual and you just had a great year. Maybe you came into a significant amount of money from some other source, but you know this is a one-time deal. You may choose to put a lot or all of that income into an RRSP in order to shelter it from taxes. In a subsequent year, when your income is much lower, you may choose to take some of that money out (at a lower marginal rate) in order to pay down mortgage or credit card debt.

What if you took a year or two off work on sabbatical or for health reasons? Your income would likely be much lower (or nil) and you would pay far less tax on an RRSP withdrawal during that year. You could use that money to pay down debt, assuming you don’t need it to live on while you’re off work.

2. Significant Increase in Your Expected Retirement Income

Supposing your income at retirement is going to be quite a bit higher than you thought. Now that’s a nice problem to have. If your future income and tax burden will be greater than your current income and tax burden, you might consider taking money out of your RRSP to pay off debt – although I’m not sure how likely it is a person who has saved so well would still have any debt.

3. You Suspect You May Have Too Much Money in RRSPs

If you started saving in the 90s like we did, you probably got caught up in the “everyone needs to put their money in RRSP mutual funds” tidal wave that swept the globe at the time. If that’s the case, you may find yourself with too much money in RRSPs. How could you have too much money?

Well, if you have so much saved that your tax burden when you withdraw the money in retirement is equal to or greater than it was during your working years, there is really no benefit to sheltering that money in an RRSP. The CRA is still going to get its pound of flesh, and part of me would rather give it now while I can still earn income rather than later when I may not be able to do so.

4. The Interest Saved on Debt Is Greater Than the Tax Paid on the RRSP Withdrawal

If you feel you have over-invested in RRSPs and you have debt that you want to get rid of, it may make sense to see how much the withdrawal will cost you in taxes relative to the interest savings you’ll receive by paying down your debt. Obviously, if you pay down credit card debt your interest savings will be a lot higher than if you pay down your mortgage. It all depends on the interest rate you’re paying on your debt.

See The Cost of Debt for some interesting math on this topic. (Is interesting math an oxymoron?)  And check out some of the calculators in the Resources section here at Balance Junkie. There is no one correct answer to the question, but you can have better odds of getting it right than a coin toss if you do a little research.

One More Caveat

If you choose to take some money out of your RRSP to pay down debt, you must be absolutely certain that you won’t take on more debt. If you pay off your credit card balances, make a pledge to never carry a balance again. If you can’t pay it off in full, don’t buy it. If you pay off your mortgage, promise yourself that you will use at least a good portion of the money that went to your mortgage payment to boost your savings. If you don’t trust yourself and/or your partner to exercise that kind of discipline, then it’s probably better to leave well enough alone.

Would you ever consider taking money out of your RRSP to pay down debt?

Related posts:

1. RRSPs: Taking Money Out
2. RRSPs: Who Needs Them?
3. RRSP vs. Paying Down Debt

Today, there are three kinds of people: the haves, the have-nots, and the have-not-paid- for-what-they-haves.

~ Earl Wilson

Update: This post was included in the 245th Carnival of Personal Finance at Budgets Are Sexy. Thanks!

RRSPs work best for the haves. The have-nots might be better off starting with TFSAs, and the have-not-paid-for-what-they-haves should pay down debt first. That would pretty much sum up my general view of using RRSPs. I recently did a telephone interview with LuAnn LaSalle of the Canadian Press on the topic, but I’m so much more coherent in writing. I think I may have sounded a bit like Porky Pig.

LuAnn was kind enough to print what I said anyway, and the Canadian Press article did a great job of getting people to question the wisdom of contributing to an RRSP every year no matter what. Even David Chilton, author and retirement savings advocate, feels like debt is the biggest problem in personal finance right now. It seems like this is a question that a lot of people are wrestling with so I thought I would try to tackle it in some detail here while RRSPs are still top of mind. Here are some things for you to think about as you decide where to put your hard-earned cash:

RRSPs vs. Debt: Factors to Consider

1. Type of Debt: Are you carrying credit card debt, car loans, a mortgage, or all of the above? Generally, it’s important to pay down the debt bearing the highest interest rate first, so this would usually be your credit card or line of credit. It doesn’t make much sense to contribute to your RRSP if you are paying the high interest rates charged by credit card companies (usually around 19%). If you have a car loan, it may also be worth your while to calculate how much interest you would save by making a larger payment on your loan. Check your loan documents or call your financing company to see if this is an option. If the RRSP tax break you’ll receive is smaller than your interest savings, it probably makes sense to pay down the debt.

Most people will put mortgage debt in a separate category because the interest rate you pay is lower, and a home is generally considered a good long term investment. I agree with that, but if you have a mortgage, you have debt. If you have debt, it’s costing you money that you could be using somewhere else. It’s worth it to calculate how much interest you will save by paying down your mortgage versus contributing to your RRSP. Another tactic is to contribute to your RRSP and use the refund to pay down your mortgage. Which is the better way to go depends on the math, and many of the other factors listed below.

2. Your Age: If you are in your 20′s, your income level is probably lower than it will be when you reach your 40′s. That means you likely have higher debt levels and less money to contribute to savings. The wisest course of action at this stage is likely to pay down your debt first and try to get your budget to a point where you are living below your means. Once you are making more money than you spend, you can build savings for retirement, buying a home, or any other goal you desire.

If you are closer to retirement, it’s more important to contribute to some type of retirement savings. But if you have credit card debt, it’s still better to pay it off before concentrating on RRSP contributions. If you are older and still carrying a heavy debt load, it’s time to get serious about eliminating that debt for good. It’s the only way to get ahead and start to really plow some serious cash into your retirement savings.

3. Amount of Debt: If you are carrying large credit card balances, you are paying a great deal in interest charges. If you’re in this boat, the first thing to do is plug the hole. Stop spending more than you earn, cut expenses and aggressively pay down your debt. If you keep spending more than you earn, the hole in your boat will get bigger, and we all know what happens next.

If you have a smaller amount of debt, you have more room to decide where to put your savings. You can always decide to put a little in your RRSP, a little toward paying down debt, and use your tax refund to pay down the debt further. Again, your decision will depend on how the math looks for your individual situation.

4. Income Level: If you are in a higher tax bracket, the tax deduction from the RRSP contribution will help you a lot more than someone in a lower bracket. But if you are in a higher tax bracket and you are carrying debt, you need to ask yourself why you would want to pay interest charges. Why let that interest compound against you rather than putting that money into savings where it can compound for you?

If you earn less than $40000 or so, the tax benefits of contributing to an RRSP aren’t as great. It’s probably better for those in this situation to pay down debt first. Once you are in a position to save, you can consider TFSAs or RRSPs, but you may want to contribute to TFSAs first. I recently threw my 2 cents in on the TFSA vs. RRSP debate if you’re interested in more information.

5.  Economic Climate: I think it’s really important to have a general idea of what’s happening in the economy at the moment and to have some ideas about what factors might affect it positively or negatively in the future. I recently outlined some reasons to be cautious right now, and I hope to keep readers up to date on these periodically. These things really can affect your personal financial decisions.

If we are in a period of lower interest rates (which may be poised to go higher) and volatile stock returns, you’ll want to factor that into your decision-making process. If you want to avoid stock market risk, you’ll need to resign yourself to lower returns for now. If you want to shoot for higher returns, you’ll need to consider investing in stocks. But be aware that losing your money is a serious risk, especially in the current environment.

2 Schools of Thought Plus My 2 Cents

There are a couple of different schools of thought out there on this question of whether it’s better to save for retirement, pay down debt, or do both at the same time. Many financial services professionals will tell you that you should always max out your RRSP contribution to the best of your ability. Personal finance guru David Bach advocates setting aside some money for savings even as you pay down your debt, with the idea that if you don’t get started now, you may never do it. I can see some merit in that argument, but I can also see the benefits of focusing on one financial goal at a time.

Many of us feel overwhelmed with the messages we receive from sources like financial professionals, books, and bloggers like myself. We’re supposed to pay down debt, and save for an emergency fund, retirement and our kids’ education all at once. For most of us, especially when we’re younger, there just isn’t enough money to go around. We can become discouraged and give up when it looks like our goals are unattainable.

As noted in a book excerpt recently published in the Globe and Mail, David Trahair, author of Enough Bull, advocates paying down all debt before you even start to save for retirement. Once you have accomplished that, you will likely be a little older, and hopefully, earning a higher income. At that point, you can put all of your savings into RRSPs and receive a greater tax break since you may be in a higher tax bracket.

I know that this view might be considered extreme, but it could in fact be a very effective strategy for those who have the discipline to achieve debt freedom relatively early. To achieve the maximum benefit from this strategy, you would also need to be very disciplined about saving for retirement rather than inflating your lifestyle once your debt was fully retired.

It can be very empowering to focus on one priority at a time. When I wrote about Your Financial Hierarchy of Needs, the point was to cover the basics first. Spend less than you earn. Develop a budget. Save for an emergency fund. Pay down debt. Save for retirement. Achieve financial freedom. Do it in that order, and don’t try to skip steps. Focus is your friend. (That’s what I was trying to tell LuAnn while doing my super Porky Pig impression.)

What are your thoughts on this topic? If you have a specific question, I’d be happy to help. Just send me an email or ask about it in the comments section below.

Related posts:

1. Should You Take Money Out of RRSPs to Pay Off Debt?
2. TFSA vs. RRSP Duel: Who Wins?
3. The Cost of Debt: Doing the Math

Life is not long, and too much of it must not pass in idle deliberation how it shall be spent.

~ Samuel Johnson

Our series on RRSP Basics continues today with some information on how and when to take money out of your RRSP.

Withdrawing Money Before You Retire

The idea behind RRSPs is that you won’t be taking any money out until you retire. But as we all know, life happens. Here’s how it works if you encounter an emergency where you absolutely need to take some of your money out:

• Any money you take out of your RRSP will be added to your income at your marginal tax rate in the year you withdraw it.
• Your withdrawal will be subject to a withholding tax which will be deducted by your financial institution. The withholding rates for Canadian residents are as follows:
  • 10% (5% in Quebec) on amounts up to $5000
  • 20% (10% in Quebec) on amounts above $5000 up to $15000
  • 30% (15% in Quebec) on amounts above $15000

*Note that you will eventually still be responsible for paying tax on your withdrawal at your marginal rate, whether that is higher or lower than the amount of withholding tax you are charged.

• If you withdraw money from a spousal RRSP, it will be taxed in the hands of the contributor if he/she made contributions to any spousal RRSP in the year of withdrawal or either of the 2 previous years. Otherwise, the withdrawal will be taxed in the hands of the annuitant (the receiving spouse). The money can generally only be withdrawn by the annuitant.
• When you withdraw money from an RRSP, you do not get that contribution room back again.

Withdrawing Money in Retirement

• You can continue to contribute to an RRSP up until December 31st of the year in which you turn 71.
• You can continue to contribute to a spousal RRSP for your spouse or common law partner until December 31st of the year in which he/she turns 71.

Once you reach the magic age of 71, you have several RRSP options:

• Withdraw the money from the RRSP: This money would be subject to withholding tax and taxed at your marginal tax rate in the year of withdrawal as outlined above.
• Transfer the money to a Registered Retirement Income Fund (RRIF): If you choose this option, there is no tax on the money you transfer, but you will pay taxes on any money you withdraw or receive from the RRIF.
• Use the RRSP money to purchase an annuity for life: Life annuities pay you a prescribed amount each year until you die.
• Use the RRSP money to purchase an annuity spread over a certain number of years: Term annuities pay you a prescribed amount each year for a certain period of time.

RRIFs

Starting the year after you set up a RRIF, you receive a minimum amount each year using a formula based on your age and the value of your RRIF. Of course the whole aim of retirement planning is to run out of life before you run out of money. In many ways, this requires that we are able to predict the future. None of us knows the number of days in our lives. We just need to plan based on what we know now and do our best to hedge against all possibilities. There is no way to get it exactly right unless you are clairvoyant.

Have you done the math yet to figure out what your retirement income might look like?

Related posts:

1. Should You Take Money Out of RRSPs to Pay Off Debt?
2. RRSPs: Who Needs Them?
3. RRSPs: What Should You Put in Them?

• Basic: These are usually provided through an advisor affiliated with a mutual fund dealer or bank who offers advice on where to invest your money.
• Self-Directed: These are plans, usually through discount brokerages, where you choose where to invest your money.
• Spousal: One spouse contributes money to an RRSP for the other. The contributing spouse gets the tax break, but the money belongs to the other spouse. In case of divorce, the assets are divided between the spouses just as any others would be.
• Group: You may have access to a group RRSP plan through your employer. Some employers will match your contributions up to a certain limit. Your choice of investments depends on the specifics of your plan. Make sure you understand the details of your group plan and figure out how it fits in with your overall investment and retirement strategy.

Where Can You Get Them?

1. Banks & Trust Companies: You can open an RRSP at any of the big banks or trust companies and they will usually provide you with some advice on how to invest your savings. Be careful, however, if you notice that all of the investments they recommend are affiliated with their bank.
2. Brokerages: You can opt for a full service or discount brokerage, and most of the big banks offer discount brokerage services as well. Each year the Globe and Mail releases a list of discount brokerage rankings. Your choice will depend on your level of investment knowledge and the way in which you want to allocate and manage your money. If you go with a discount broker rather than a full service outfit, you will likely be choosing a self-directed RRSP.
3. Financial Advisor: Often advisors are affiliated with a mutual fund dealer and as such will only recommend mutual funds for your RRSP. While this may be a good strategy for you, be aware that you have many other alternatives, some of which may be more appropriate for you. If your advisor isn’t willing to explain them to you, you may want to find a new one.
4. Credit Unions: If you belong to a credit union, check out the types of RRSP products that they offer. These may include RRSP savings accounts, GICs, mutual funds, and more.
5. Insurance Companies: Many insurance companies offer RRSPs as part of an overall financial plan. They may offer GICs and mutual funds, but most specialize in annuities.

What Can You Put in Them?

1. Savings Accounts: If you want the lowest risk, most liquid place to park your RRSP cash, this is the ticket. The only catch is that, while your deposits will likely be CDIC protected up to $100000, you will earn very little interest on your deposits as long as rates remain low as they are now. Some of the banks that offer higher interest savings accounts (like Ally and Canadian Tire Financial) do not offer RRSP versions of their savings accounts. ING Direct and PC Financial do offer high interest savings accounts under the RRSP umbrella, but ING Direct currently has the better rates.
2. GICs: Guaranteed Investment Certificates are also safe, CDIC protected places to invest your RRSP money. They are available in terms that generally range from 90 days to 5 years. You can find shorter or longer terms, but these are the most common ones out there. Usually, the longer you lock up your money, the higher the interest rate you’ll receive. Right now, ING Direct is offering a 3% rate on a 90 Day GIC. This is a great deal, as the 5 year GIC is only paying 3% as well. (Note: I have no affiliation with ING Direct right now. I’m just a satisfied customer.)
3. Mutual Funds: Mutual funds are groups of equities or bonds (or both) that you can purchase in the form of units. You can usually sign up for monthly contributions or add lump sums to your investment as you like. Beware of fees with these products. Make sure you understand exactly what you are paying for the fund and to your advisor, if you’re using one.
4. ETFs: These are like mutual funds, only they are usually associated with much lower fees and are more often available through discount brokers rather than advisors.
5. Stocks: You can include the stocks of individual companies in your RRSP if you use a full service or discount broker.
6. Bonds: You can buy individual government or corporate bonds through a broker. You can also invest in bonds through mutual funds or ETFs that may represent a variety of bonds linked to a bond index. You can concentrate on corporate or government bond indices individually, or you can buy an ETF or mutual fund that contains a mixture of both.
7. Options: Options are investment vehicles that are derived from stocks or other financial instruments. They are fairly complicated for the average person and I don’t have enough knowledge in this area to give you a great deal of detail on them. They are, however, RRSP eligible. Still, unless you really know what you’re doing, leave them to the experts.
8. Your Mortgage: Yes, you can technically hold your own mortgage inside your RRSP. I have read a little about this, and it is usually not recommended, except in a few specific circumstances. It seems pretty complicated and I would again caution against swimming in the deep end of the pool unless you really know what you’re doing.

What Should You Put in Them?

The answer to this question will depend on your unique situation. Generally, your asset allocation will depend on your risk tolerance. The higher your risk tolerance, the larger your concentration on stocks, or mutual funds and ETFs that contain stocks. Bonds are less risky, but not risk-free. GICs and savings accounts contain the least risk. Here are some factors to consider:

• Age: Your age will usually determine your retirement time horizon (unless you are a 28 year old whiz kid who is already independently wealthy). Generally, your time horizon will determine how much risk you are able to take in your investments. As you get closer to retirement, you should own fewer stocks, more bonds, more GICs and perhaps a high interest savings account. If you are 10 to 20 years or more from retirement, you can afford to take a little more risk if you like.
• Your Other Investments: What other assets do you own? A home? Non-registered stocks, bonds, etc.? You need to make sure you are diversified across all areas of your financial life both inside and outside your RRSP.
• Your Unique Personal Situation: Your marital status, the number of children you have, your income level, job stability, and health status are just a few of the factors that might affect how and where you allocate your RRSP dollars. The more risk in your personal situation, the less risk you should take in your investments.
• Your Personality: Some people like to take more risks. This can spread to their investments as well and there is nothing wrong with that, so long as they are fully aware of and OK with the level of risk to which they are exposed. Knowledge is power. Always know the maximum that you can lose.

This is meant to be a discussion of RRSPs at a very basic level and it is far from complete. Still, I hope it has you thinking about your retirement plans and how you want to handle them.

What’s your RRSP strategy? How do you decide where to allocate your assets?

Related posts:

1. RRSPs: Who Needs Them?
2. RRSPs: Taking Money Out
3. Book Review: Enough Bull

Warning:  Dates in Calendar are closer than they appear.

~ Author Unknown

Registered Retirement Savings Plans (RRSPs) were introduced by the Government of Canada in 1957 as a means of encouraging Canadians to save for retirement. That need has only grown over the decades as corporate pensions have been cut and the number of companies matching contributions has dwindled.

Many pension plans took a huge hit when the stock market fell in 2008 and 2009. Although they have since recovered a lot of their losses, the crash reminded us that money in the stock market is money at risk.

To make matters worse, Canadians have been saving less, taking on more debt, and keeping that debt on their balance sheets for longer than in the past. In October of 2009, The Globe and Mail ran an excellent series entitled Retirement Lost which outlined many of the issues facing Canadians as we plan for retirement. These are issues that people are grappling with globally. They are issues that are important to our future, but are sometimes hard to find the time to address in the present.

‘Tis the Season

January and February are often the busiest months of the year for RRSP providers as taxpayers rush to decide how much they want, need, or can afford to contribute to their RRSPs for the 2009 tax year before the deadline (March 1, 2010). We will be bombarded by advertisements and maybe calls from our financial advisors warning us that we must contribute the maximum amount that we can to our RRSPs before the deadline. For some of us, this is probably a good idea. For others, maybe not so much. This begins a series of articles on RRSP Basics that will hopefully help remind us what RRSPs are really for – and what to watch out for to make the most of your contributions.

Main Benefits

1. Tax Deferral:  Savings and investments held inside an RRSP are not taxed as income in the year you deposit them. You will not pay taxes on that money until you withdraw it from the RRSP. This means you might receive a refund on your tax return depending on your income situation.
2. Tax Sheltered Growth: In addition to paying no tax on the money you put in your RRSP, you will not pay taxes on any interest, dividends or capital gains that accrue until you withdraw the money. As a result, some experts recommend that you hold interest paying investments inside your RRSP and those with capital gains outside your RRSP, since interest is taxed more than capital gains.

Should You Save in RRSPs or Not? Michael James on Money did some math for us in a good article that discusses the benefits of tax free compounding.

The Cardinal Rule of RRSPs

If you had to boil down whether or not an RRSP is a good idea for your situation to one basic test, I guess it would be this:

Is your marginal tax rate at the time you put the money into the RRSP greater than it will be when you take it out?

1. Yes: If you know that the answer to this question will definitely be yes, then putting money into an RRSP is a great way to give yourself a tax break now, save for retirement, and grow your investments tax-free until you are ready to take the money out.
2. No: If your marginal rate in retirement is going to be less than or equal to what it is now, or if you are consistently in a lower tax bracket, you may want to think a little harder about whether or not it makes sense to contribute to an RRSP. On one hand, you still get the tax break and tax-deferred gains. On the other hand, money you take out of an RRSP will be added to your income. This can lead to clawbacks in other government programs like GIS (Guaranteed Income Supplement) and OAS (Old Age Security). If you fall into this category, TFSAs are the way to go for tax free compounding, and zero clawbacks.
3. Not Sure: If you live with variable income, or you are just starting out and don’t know where your income might be headed, it may be better to take your decision one year at a time. If you have a high income year, that would be a good time to put some money into an RRSP. But don’t forget that if you have highly variable income, you should have a big, fat, liquid emergency fund before you invest a whole lot in RRSPs. If you are younger and it looks like your career is on a good track, go ahead and get started on your RRSP – as long as you are free of consumer debt. If not, pay off your debt first.

What to Watch Out For

1. Fees: No matter which vehicle you choose for your RRSP investment, make sure that you are clear on all fees that are involved. Most providers charge a transfer fee anywhere from $25 to $150 or more if you want to to transfer your RRSP to another institution. There are usually some kind of fees inherent in most investments as well. Look at the MER (Management Expense Ratio) of any mutual fund or ETF you buy. Anything over 2% is probably too much, and you should try to get it under 1% if you can. A single percentage point can make a huge difference over a decade or more of investing. Be particularly careful with DSC (Deferred Sales Charge) mutual funds sold through advisors. Make sure you understand exactly how they work.
2. Content: There are numerous options for where you can put your RRSP money. We will detail some of them tomorrow. But for now, make sure you consider your RRSP investments in the context of your overall financial situation and investment portfolio. Make sure you are diversified across your entire financial landscape.
3. Marital Status: If you are married and one spouse earns a lot more than the other, it may be wise for the higher income earner to contribute to a Spousal RRSP. The higher earner gets the tax break up front but the money is taxed in the hands of the lower earner upon withdrawal (as long as it’s been in there for at least 3 years). This type of income splitting in retirement is not as big an issue as it used to be since 2007 when the government began to allow some pension splitting between spouses.
4. Government Rule Changes: All of our RRSP planning is based on the rules set out by the government. They can and do change the rules on us from time to time. Back in 2005, the government removed the foreign content limits on RRSPs, allowing us to invest in more U.S. or other foreign investments if we so choose. It just pays to keep on top of legislative changes that may affect your investment strategy.
5. Revisit Plans Annually: It’s a good idea review your overall investment strategy at least yearly, monitoring any changes in the above factors that may affect your decisions surrounding retirement planning.

Do you have any questions or insights about RRSPs or retirement savings in general? If so, include them in the comments section or send me an email and I’ll try to address them.

Related posts:

1. RRSPs: Taking Money Out
2. RRSPs: What Should You Put in Them?
3. Should You Take Money Out of RRSPs to Pay Off Debt?