If you’ve heard of the RRSP then you’ve probably been told that you should be contributing to it. But, should you?
Since the RRSP is a way for people to invest their money and save on taxes, it seems like a great place to put your money.
The more you invest early on the better off you’ll be, in general. This is misleading though when you’re told to put money into your RRSP. It’s actually somewhat opposite to the typical investing mindset. It’s usually a bad idea to invest in your RRSP early on in your life. To understand why, you need to understand the basics of what the RRSP does and how to use it effectively.
The RRSP (Registered Retirement Savings Plan) is a Canadian savings account. You can put a maximum of 18% of your income each year into your RRSP. If you don’t contribute to your RRSP, or don’t contribute the maximum amount, the leftovers accumulate going forward each year forever.
There are two reasons that most people have for putting money into their RRSP.
The first is that you get a tax refund when you contribute. So for example if you were being taxed at 25%, and you added $5000 to your RRSP, you’d get $1250 back.
The second reason is that normally if you sell stocks you own, you have to pay a capital gains tax. Or if your investments are earning a dividend, you have to pay taxes on those dividends. Yet, while your money is in the RRSP you don’t have to pay any taxes.
This all seems great, but there’s one problem. What if you want to use the money in your RRSP?
Using the money in your RRSP
While it’s nice to see a number get bigger in your account, it’s meaningless unless you can actually use it. The government prefers that you wait until you retire at age 71 to take any money out of your RRSP. Consider that you won’t be able to use this money for most of your life to buy a car, go on vacation, or almost anything. Assuming you’re fine with that, let’s look at what happens when you take your money out.
At the age of retirement (currently 71) you have two options: take all the money out of your RRSP, or convert it to an RRIF.
If you take your money out of the RRSP, you have to pay taxes on it. Remember that money the government refunded you when you contributed to your RRSP? They want it back now. Not only do you have to pay taxes on that money, you might actually pay more taxes than you would have originally.
An RRIF (Registered Retirement Income Fund) is a way to take your RRSP money out in smaller chunks, to avoid taking a huge tax hit. There is a minimum amount you must take out every year, but you can take out more if you want to. Again, you have to pay tax on the money you’re withdrawing.
Alternatively, you can also take the money out of your RRSP whenever you want, but you will have to pay the tax on it. Also, if you take the money out before the age of retirement then you will lose that contribution room. For example if you withdraw $10,000 and you had room to contribute $25,000, you now only have room to contribute $15,000.
Losing money with your RRSP
So, the RRSP doesn’t always save you from taxes. A better way to think about the RRSP is that it delays your taxes, but you still have to pay them. If we look at an example, it will become clearer.
Let’s say you live in Ontario with an income of $50,000, we can calculate your max RRSP contribution for that year as $9,000. Then we can calculate the taxes you save from that $9,000 as $2,411. So now you have $9,000 in your RRSP and an extra $2,411 cash. For the sake of this example, you will also invest the $2,411 tax returned.
Then let’s skip ahead 10 years, your salary has increased to $75,000 and your investments have doubled in value. So you have $18,000 in your RRSP and $4,822 from the refund you also invested. You have to pay capital gains tax on that investment outside your RRSP, so you instead have roughly $4,442. Now you decide you need that money in your RRSP so you withdraw that $18,000 too. After paying tax on your RRSP money you end up with $11,759, and if we add the refund you invested you have $16,201. So you started with $9,000 and ended up with $16,201.
Now, had you decided not to use your RRSP at all and invested that $9,000 let’s see what you end up with. We said after 10 years it doubled, so again you have $18,000. Your salary is $75,000, so we can calculate your capital gains tax to see that your investment after tax is $16,474. So, using the RRSP would have actually cost you $273.
Using your RRSP effectively
Although you have to be careful with the RRSP, since you can lose money, that doesn’t mean it’s bad. The main problem with the RRSP is that the government taxes any money you withdraw as income. With capital gains you only pay tax on half the gains, and you pay even less tax on dividends. But when you withdraw from the RRSP it’s all taxed as normal income.
The ideal scenario is to invest in the RRSP when you’re at a higher tax bracket, and then withdraw from it when you’re in a lower tax bracket. That way you actually save money by paying less taxes. Though it’s hard to do this, because as you get older you usually earn more money. It’s also somewhat risky, because you’re betting on making less money in the future, but that might not be the case.
Other RRSP benefits
There are a few other benefits to the RRSP. The first is that you can take out up to $25,000 from your RRSP to pay for your first home. It comes with a caveat though, you must pay that $25,000 back into your RRSP over a period of up to 15 years. So it’s essentially an interest free loan.
The second benefit is similar, you can take up to $20,000 for the Lifelong Learning Plan. You can use this money for training or education. Again, you must pay it back into your RRSP, this time over a period of 10 years.
One other thing to consider, is that many companies offer matching programs for their employees up to a certain amount in their RRSP. So if you contribute $1,000, they may also contribute another $1,000 on your behalf. Usually you’ll want to max out whatever amount they’re willing to match up to.
Introducing the TFSA
So the RRSP is interesting, if you use it properly you can save money on taxes. Contrary to the RRSP is the Tax-Free Savings Account (TFSA). There’s no trick to this, any investments you have in your TFSA are free from taxes. So you don’t pay capital gains tax or dividend taxes at all. If we go back to our earlier example of investing $9,000, if you had put that into your TFSA and it doubled, you’d have $18,000. That’s after tax, because there’s no tax to pay.
Not only is this much simpler, it will usually save you more money and you don’t have to wait to withdraw it. You are allowed to withdraw money whenever you want, without any penalties. There is a limit to what you can contribute though, currently it’s set to $5,500 per year. It also accumulates from when you are 18 years old, so if you aren’t able to contribute, you can add more in later years.
Paying for your kid’s education with an RESP
One other tax saving account to consider (if you have kids) is the Registered Education Savings Plan (RESP). The growth from this account is still taxed, but your kids are the ones paying the tax. Since your kids will have low or no income, they will be taxed at the lowest rate. Also, you can get the Canada Education Savings Grants (CESG). It will match 20% of your contributions each year, up to $500.
It’s debatable whether this is better than a TFSA in saving for your child’s education. But, it does make sense to contribute $2,500 to get the $500 government grant.
Putting it all together
So, where should you put your money? Well, it depends on your financial situation and where you think you’ll be in the future. But, generally speaking you should be trying to max out your TFSA first, and then consider if it makes sense to use your RRSP. You should not feel compelled to use an RRSP, since it could actually burn you. Especially if you are younger, it’s very unlikely you’ll be in a high enough tax bracket to make use of the RRSP.
The only consideration over the TFSA would be if you are paying for post-secondary education for your child. In that case you should take advantage of the government grants.
There are a few questions you need to ask yourself. How long can you wait to use the money? How much money will you be earning when you retire? What is this money for and what are your goals? If you can answer these, you’ll be able to make the right choice. You should also talk to a financial advisor and/or accountant to help you make the final decision.