Beware of RRSP Season
Originally Published on February 5, 2019
Updated January 23, 2020
By any chance, have you been off the grid for the last month or so? No? Then I am certain that you have seen an advertisement for RRSPs during that time.
This is a big season for the average bank, fund provider, asset manager and just about anyone else involved in the investment or financial services industry.
The reason that this is such an important time is simple – RRSP sales. And why are RRSP sales so important? RRSPs stay invested – for a long time.
Let’s use a simple example. In this example, you invest $10,000 in an average mutual fund within your RRSP. You are 30 years old when you contribute and plan to retire at the age of 65. Let’s say this mutual fund has a 2% Management Expense Ratio (MER) and grows at a rate of 5% a year. By the time you reach retirement, the mutual fund will have earned $10,326 in fees over that 35-year period. $10,000 of income, from a single contribution! In addition, you will keep your funds invested throughout your retirement as you withdraw from your RRSP as a source of income. This example doesn’t contemplate admin fees, transaction fees, or management fees paid to your advisors. These fees would be over and above the MER for the mutual fund.
As you can see, RRSPs are BIG business for the industry.
The problem with the sales cycle that we all endure during the early part of the year is that it doesn’t contemplate the most important factor. YOU!
Blindly contributing to your RRSP is not a winning financial strategy. When deciding whether you should contribute to your RRSP, you should take into consideration your individual financial situation.
Isn’t Saving For Retirement A Good Thing?
Absolutely! Start saving. Right now. Start yesterday if you are somehow able to do that.
According to a study by BDO, nearly two-thirds of Canadians say that they don’t have much, or anything, saved for retirement. A key statistic from the report is that 47% of millennials have no retirement savings.
Saving for retirement helps to solidify your financial future. Of the people surveyed in the study, 75% of those who haven’t retired yet expect to work longer than their parents did.
Saving for your retirement is critical and I encourage you to do so, but blindly contributing to an RRSP is not the only way to achieve either your retirement or your broader financial goals.
Is An RRSP Contribution Right For Me During RRSP Season?
There are several considerations to take into account when determining your tax and retirement strategy. RRSPs are an integral component of both. Here are a few of the key items that you should keep in mind.
Am I carrying credit card debt?
Not only is it RRSP season, but it is also the time of year that we have to pay off our credit cards from the December spending spree. Paying down high-interest credit card and other types of debt should be prioritized over contributing to your RRSP.
Do I have an emergency fund?
Retirement is a long way away for some. You need to get there first.
An often-overlooked area for most, an emergency fund is mandatory to weather the ups and downs of life. Identity theft, cracked foundations, leaky roofs, unexpected medical expenses, job loss, serious injury, elderly parents in need of care, vehicle breakdown or a surprise baby on the way. These are just a sampling of the reasons that you should ensure that you have an adequate emergency fund at the ready.
Can I lock these funds in until retirement?
An RRSP isn’t a typical savings account. When you put money into one, the general expectation is that you will keep the money there until it is time to fund your retirement. As such, you won’t have access to the funds without penalty. Funds that are withdrawn early experience 2 major consequences.
First, the funds withdrawn have a withholding tax applied against them. The Federal withholding tax rate is 10% for withdrawals up to $5,000, 20% for withdrawals between $5,000 and $15,000, and 30% for withdrawals over $15,000. In addition, if you live in Quebec, there is also a provincial withholding tax. This means, that if you live in Ontario will need access to $15,000, you need to withdraw roughly $19,500 in order to be left with the cash that you need after federal withholding tax. When you file your tax return for the year of withdrawal, the $19,500 would be included in your income. If you have a marginal rate below the 30%, you should receive a refund for the difference, but you have just given the government an interest-free loan for the period between your withdrawal date and when your tax refund gets paid out. If your marginal rate is greater than 30%, then you now need additional cash to cover the tax bill for the difference in tax rates.
Second, you lose the RRSP contribution room forever. Unlike a TFSA, when you make a withdrawal from an RRSP, you do not get to put the withdrawal back in. With a TFSA, you can re-contribute the amount that you withdrew in the following year.
What is my marginal tax rate, and what will my tax rate in retirement be?
This is the money maker when it comes to using RRSPs. The best use of an RRSP is when you contribute money at a higher marginal tax rate than your planned marginal tax rate in retirement. In a simple example, if you contribute at a 30% tax rate, but withdraw at a 35% tax rate, you will be paying more tax than you would have saved on the contribution.
That being said, the tax-deferred treatment of the investments within an RRSP can still result in a positive outcome despite the above tax rate scenario. This will depend heavily on investment performance and the length of time the funds are invested. Whether or not this will make sense for you will depend on several factors, however.
How much tax do I have to pay this year?
One of the immediate benefits of an RRSP is that it reduces your tax payable in the current year. contributions made in tax years with higher marginal rates than are typical for you, provide the best bang for your buck. If you contribute too much in the wrong year, you may be wasting some of the taxation magic that an RRSP contribution can provide given that contribution room is limited. Which is a great segue…
How much contribution room do I have?
Unfortunately, the benefits of an RRSP are not unlimited. You accrue 18% of your employment income as RRSP contribution room every year, up to a maximum of $27,230 in 2020. If you have a limited amount of contribution room, you may be better served by using it in a later year when your marginal tax rate is higher.
Do I already have enough in my RRSP?
There is also the possibility that you don’t need to make any contributions. If you have a workplace defined benefit pension, this may satisfy your retirement income needs by itself. This is not a typical scenario, however.
Another scenario of note is where you have ample RRSP savings already to fund your retirement needs. In this case, additional contributions you could put yourself in a position where when you convert the RRSP to an RRIF you will end up in too high a tax bracket. If this is the case, TFSA, non-registered accounts or Spousal RRSP contributions are more appropriate for your situation.
Buyer Beware: RRSP Loans
Another tactic that the financial industry likes to use is the offering of RRSP loans.
The general idea is that you take out a loan to contribute to your RRSPs, and then pay off as much of the loan as you can with your tax refund.
The major problem with this approach is that when you borrow money to invest in an RRSP, the interest that you pay on the loan is not tax-deductible. In addition, as with most loans, there is an inherent risk. The risk here is that unforeseen events could arise, or you simply get invited to go on a great spring break trip, and you may not pay the loan off in full. All the while, you can’t deduct the interest because it was used to fund your RRSP. Not a winning play.
Your Bonus & RRSP Season
Another item to consider is that this also happens to be around the time when many employee bonuses are paid out. If your employer offers a savings program, such as a Group RRSP, then typically your employer will provide you with the option of having your bonus paid straight into your workplace RRSP plan. In addition to the items mentioned above, there are additional considerations to keep in mind around this option.
What is the timing of the bonus payment?
This is critical from an RRSP perspective. If the bonus will not be paid until after March 1, 2020, then it won’t be eligible for your 2019 tax year filing. If this is paid prior to March 1, and you elect to contribute it to your Group RRSP, then you would have the option to apply it to either the 2019 or 2020 tax year.
A word of caution on the prior to March 1 example – your bonus will be taxed as income in 2020 regardless. If you contribute it and elect to use the RRSP deduction for the 2019 year, you would still have to pay the income tax on it in the 2020 tax year, but with the cash flow of the bonus to cover the tax owing. As such, this would not be a generally recommended approach.
What are the fees associated with my Group RRSP?
This is one that you will have to do some research around. Mind you, this is research that I would recommend you perform no matter what. Gaining an understanding of the investment products that are offered as part of your employer-based savings plans, and their fees will help piece together the overall cost of your portfolio. While the fees associated with the products offered can vary, there may be an offsetting benefit to utilizing the savings plan, such as an employer savings match. For example, if you contribute 5% of your savings each month into the plan, they may offer to match this 5%. A 100% match of your money will offset the increased fees that they may offer.
However, when it comes to your bonus, there won’t be an accompanying match on your contribution (like a standard pension contribution). High fees may make this option an unattractive one.
Do I need the cash from the bonus payment for another purpose?
If you do not contribute your bonus to the savings plan, this will be paid out just like your normal paycheque. However, there will be one key difference. When the bonus gets paid out, there will typically be a withholding tax at a fairly high marginal rate, along with CPP and EI deductions. Similar to the early RRSP withdrawal example above, this means that some of your money may be tied up until you file your tax return in 2021, for the 2020 tax year, and get your refund.
The Brass Tacks
RRSPs are powerful financial tools.
The financial industry is full of intimidating salespeople.
The combination of these facts can result in some unwise decisions being made.
In order to determine whether contributing to your RRSP is the right thing for you, there are a number of important factors to consider. You shouldn’t simply blindly contribute to your RRSP like the salespeople would like you to.
To discuss your tax and RRSP strategy for the coming year as part of a Fee-Only Financial Plan please contact us.
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