To RRSP or Not to RRSP – That Is the Question!
Every year, clients ask me if they should contribute to their RRSP’s. Usually, the answer is yes. With only a few weeks left to make that decision, I thought I’d share some last minute thoughts on the subject. For starters, my experience as a financial advisor has been that the primary reason many, if not most, Canadians contribute to their RRSP’s is to reduce their income taxes or generate a refund. RRSP’s, therefore, are seen less as a vehicle for retirement savings than as an instrument for tax management. From both a cash flow standpoint and a return on investment standpoint, the most effective way of contributing to your RRSP is to spread your contribution out over the course of the year. While ideally, Canadians should be making regular contributions to their RRSP’s, year after year, many Canadians leave a key financial opportunity on the table by not contributing the maximum allowable amount into their Registered Retirement Savings Plans. Although it may seem difficult to find the money to contribute into your RRSP every year, we can show you a number of strategies to consider that can help accelerate your plan using assets you have readily available and key tax planning benefits.
Know Your Limits
It’s important to know how much contribution room you have prior to sitting down with your advisor to discuss your RRSP strategy. Each year, the Canada Revenue Agency identifies your unused contribution room for the upcoming tax year on your Notice of Assessment, or you can call to the Canada Revenue Agency at 1-800-959-8281 or visit www.cra-arc.gc.ca .
It may be to your benefit to move money you currently have in savings accounts, a Tax-Free Savings Account or other investments into your RRSP sooner, rather than later. Moving these dollars into your RRSP will not only result in a reduction of your annual tax bill, but will also allow you to maximize growth inside your RRSP, without generating immediate taxable income. Be aware of the potential tax implications when selling off non-registered investments.
Consider the Benefits of Borrowing
In many cases, borrowing to take full advantage of RRSP contribution room makes sense. Maximizing your RRSP contribution now offers immediate tax savings this year and tax-deferred potential growth for many years to come. Our advice on RSP loans is to treat them with caution. The terms are attractive; the interest rates are preferred; and other features such as deferred payments are favourable. But it’s still a loan with an interest cost. Talk to us before committing to an RSP loan. The tax minimization benefit of RRSP’s is widely touted as sound financial planning and tax planning. What we lose sight of is that this tax minimization applies only to the year in which the contribution is made. You could, therefore, be creating a ticking tax time bomb in retirement by contributing to your RRSP today if you have significant retirement income coming from other sources. This is particularly true for those who have generous retirement pensions such as teachers and public servants.
We need to ask which is more valuable to us: the tax deduction now, or retaining our savings when we’re retired and living off a fixed income? The answer to that question depends on our level of income today, our cash flow situation, and the reliability of our income both now and in retirement. It’s not an easy question to answer. One option is to invest some of our retirement savings outside our RRSP. We would not be subject to annual withdrawals; any withdrawal would not be counted as earned income and erode OAS eligibility; and each dollar out of a non-registered plan is treated differently for tax purposes, resulting in a tax treatment of no more than half what it would have been had the money been in an RRSP, and as little as one fifth the tax! And today, with the option of a Tax-Free Savings Account, it’s even more attractive not to invest in an RRSP. The money earned within a TFSA and all money withdrawn from it is tax-free – entirely and forever.
The bottom line is that it’s important to invest for our retirement, even if we have a pension (for many people, if not most, a pension will not be sufficient in retirement).
The question is where to put it: RRSP, TFSA, or Non-registered plan?
If it’s far more important to reduce our taxes today, then an RRSP looks very appealing. If, however, cash flow isn’t an issue during our working years and we’d prefer to minimize taxes in retirement, then a TFSA, or a Non-registered plan, might be preferable. While I can understand the desire for a tax refund in the months following the Holidays, it could make far more sense to live within our means throughout the year and avoid the need for a refund in April. That doesn’t mean we can ignore RRSP’s as our retirement savings vehicle; in fact, if we don’t need the cash from the refund, we may still prefer to put our money in an RRSP. By taking the refund and reinvesting it, either in our RRSP or a TFSA, we can generate even more benefit than opting for a TFSA alone.
Consider the following:
If we took $5000 and invested it in an RRSP today at an annual average return of 7%, it would be worth $27,137 in 25 years. The same $5000 invested today in a TFSA at an annual average return of 7% would be worth the same amount in 25 years. However, in the case of the RRSP investment, the initial contribution generated a tax refund (or reduction in taxes) of $1750, assuming a marginal income tax rate of 35%. The tax on the matured value of the RRSP in 25 years would be $8141.10, assuming a tax rate in retirement of 30%. Our net benefit on the RRSP investment, therefore, is $15,756 ($27,137 – $5000 + $1750 – $8141).
In the case of the TFSA, the net benefit would be $22,137 ($27,137 – $5000). It would appear that the TFSA offers more financial advantage than the RRSP. Not so fast. If we had taken the $1750 tax refund from our RRSP contribution and invested it immediately into a TFSA, it would grow to $9498, given the same assumptions. The total proceeds available to us in retirement are now $23,504 – some $7748 more than had we not reinvested the refund, and $1367 more than the TFSA alone. There is also the option of investing the refund back into our RRSP, and repeating that reinvestment until the refund became so small as to be impractical to reinvest.
Remember, there is no one-size-fits all solution. In fact, there is a multitude of variables that must be taken into consideration. In many cases, the TFSA should be used as a complementary vehicle, along with your RRSPs, as they both have their own advantages. Your personal savings strategy needs to take into account your unique circumstances as well as your short and long-term objectives.
TFSA’s and Non-registered plans are useful to those with generous pensions for another reason: you don’t get a lot of RRSP contribution room each year because your pension contributions eat up most of it. If you’d like to invest more than you’re allowed, you must look outside your RRSP.
And, if you’re a Federal Government employee, or an employee of a company that offers a severance at retirement, then it’s important to leave a lot of contribution room in your RRSP to accommodate your severance payment. If you take the severance in cash, it’s added to your taxable income and taxed at your marginal income tax rate, whereas any amount transferred into your RRSP avoids the income tax upon payment (even though it is taxable when withdrawn). There are many public servants who have opted to take their severance at retirement and may need additional room to roll their retirement allowance into their RRSP’s.
Scott Boassaly is a Mentor at Aspire-Canada and Financial Advisor at J.R. Saint and Associates.