RRSPs: Who Needs Them?

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.