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 post will hopefully help remind us what RRSPs are really for – and what to watch out for to make the most of your contributions.
- 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.
- 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?
- 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.
- 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.
- 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
- 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.
- 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.
- 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.
- 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.
- 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.
There are a few types of RRSPs that you can get:
- 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 or robo-advisors, 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?
- 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.
- 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.
- 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.
- 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.
- 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?
- 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 Tangerine and EQ Bank) do not offer RRSP versions of their savings accounts.
- 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.)
- 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.
- 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.
- Stocks: You can include the stocks of individual companies in your RRSP if you use a full service or discount broker.
- 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.
- 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.
- 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.
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.
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.