Book excerpt

RRSPs: How big does yours need to be? Add to ...

Reprinted by permission of the publisher, John Wiley & Sons Canada, Ltd, from Cash Cows, Pigs and Jackpots: The Simplest Personal Finance Strategy Ever. Copyright© 2012 by David Trahair.

If you have determined that the amount of income you’ll need exceeds the total you are going to receive from CPP and OAS, you are going to need other sources of funds.

As we have discussed, it used to be common for this to be provided by employer-sponsored defined benefit (DB) plans. If you are one of the lucky ones to have worked for a company or government with a healthy DB pension that is adjusted for inflation, you may be set for life.

For the rest of us, a Registered Retirement Savings Plan is the most common answer. It needs to be large enough to provide the income to make up the difference between what you spend and what is covered by your CPP and OAS pensions.

Say, for example, you determine that you and your spouse will need \$5,000 per month before tax in 2012 to live. Assume you each get \$1,500 a month from CPP and OAS (a little less than the maximum) for \$3,000 a month total. That means you’ll need an RRSP to pay out \$2,000 every month from retirement until your demise. That is \$1,000 a month each.

The next issue is how long you’ll need the money for. How long are you going to live?

Let’s say you both will probably live to 85. That means each of your RRSPs at age 65 would need to be large enough to pay out \$12,000 a year for 20 years.

Using a business calculator, a payment of \$1,000 per month over 240 months (20 years), assuming the RRSP makes 5% per year, would mean an opening RRSP value of \$152,156.

So your and your spouse’s RRSPs combined would need to be worth a total of \$304,312 at age 65.

But real life is a bit more complicated than this. How are you going to make a rate of return of 5% per year on your investments without taking undue risk? What happens if you have health concerns and need more than \$5,000 a month?

Unfortunately, problems like these are more than likely to happen to you. The only way to ensure you are better able to deal with issues like this is to start getting your cash flow under control early in life. Leaving it until you are 75 years old is too late—you probably won’t have the funds you’ll need to live out your life in comfort.

Let’s deal with the key issue when it comes to RRSPs, which is what happens when you turn 71.

Age 71: The End of Your RRSP

The year you turn 71 you have to convert your RRSP to a Registered Retirement Income Fund (RRIF) or an annuity. This is a vital decision as it will have a significant effect on the cash flow from your retirement savings going forward.

Registered Retirement Income Fund (RRIF) or Annuity?

An RRIF is simply your RRSP with a different name. You can transfer all the investments in your RRSP to your RRIF without triggering any tax so it’s usually as simple as changing the name on your account. Once an RRIF is established there can be no more contributions made to the plan, nor can the plan be terminated except through death. You are allowed to take out as much as you want each year as there are no maximum withdrawal amounts. There are, however, minimum annual withdrawal amounts, depending on your age. We’ll discuss those further below.

With an annuity, you purchase a contract from an insurance company with your RRSP funds and they guarantee to pay you a certain amount each month for life.

Let’s explore the details of each.

RRIFs: The Details

The key thing to realize with RRIFs is that the government has minimum amounts that you must withdraw before December 31 of each year, depending on your age. If you have a younger spouse or a common-law partner, you can base it on his or her age. This would result in you having to take out less than if you used your age because the percentages increase with age.

Minimum RRIF Withdrawal Amounts

The minimum amounts are set by legislation and are expressed as a percentage of the opening market value of the RRIF account. If you establish an RRIF early, the percentage is 1/(90 – age). This applies up to age 70. So someone who is 70 would need to take out 5% (1/90 – 70).

Here are the percentages for RRIFs established after 1992 for age 69 and up:

RRIF Minimum Withdrawal Rates after 1992

 RRIF Minimum Withdrawal Rates after 1992 Age % Age % 71 7.38% 83 9.58% 72 7.48% 84 9.93% 73 7.59% 85 10.33% 74 7.71% 86 10.79% 75 7.85% 87 11.33% 76 7.99% 88 11.96% 77 8.15% 89 12.71% 78 8.33% 90 13.62% 79 8.53% 91 14.73% 80 8.75% 92 16.12% 81 8.99% 93 17.92% 82 9.27% 94 or older 20.00%

With an RRIF you have flexibility. You can invest in a wide range of things, from fixed-income products such as GICs to stocks and mutual funds. You can also take out as much as you want each year, as long as it is above the minimum amounts.

But with this flexibility comes risk. What if you are over-exposed to equities and the stock market crashes again? What if you have a spending issue and end up taking out too much in the early years and don’t have enough to last you to the end?

Purchasing an annuity with at least some of your RRSP might make sense.

Reprinted by permission of the publisher, John Wiley & Sons Canada, Ltd, from Cash Cows, Pigs and Jackpots: The Simplest Personal Finance Strategy Ever. Copyright© 2012 by David Trahair.