“Too soon old, too late smart,” goes the proverb. Many long-time holders of registered retirement savings plans may be nodding their heads in agreement. If you are relatively new to RRSPs, or want to avoid missteps, here are 13 prevailing errors, in four categories:
Saving too much
1. Those who make contributions at lower tax brackets and accumulate a nest egg large enough to boost retirement income into the higher tax brackets could end up paying more income taxes over their life. Also, Old Age Security and other federal and provincial means-tested benefits can be clawed back.
2. When holders of RRSPs reach 71 they are compelled, regardless of personal circumstances, to wind them up. Funds have to be withdrawn and taxes paid, or they must be rolled into annuities or registered retirement income funds (RRIFs) and tax paid on the subsequent distributions.
3. Post-RRSP annuities and RRIFs can be restrictive. For example, RRIF withdrawals are mandatory, begin at 7.38 per cent of the plan’s value for 72-year-olds, and rise steadily to 20 per cent by age 94. If you have a large RRSP, these withdrawal rates may give you a lot more money than you need in given years. Furthermore, when interest paid on RRIF funds is low, as it is now, recipients could run out of funds.
4. On the death of the surviving spouse (or disabled child), RRSPs and RRIFs become fully taxable. The substantial payments to Canada Revenue Agency can be a shock to heirs when balances in a plan are large enough to be taxed mostly at the highest marginal rate.
Misallocation across accounts
5. Advisers often encounter investors who hold growth and dividend stocks in their plans and keep interest-bearing investments in their non-registered accounts. Tax-advantaged capital gains and dividends are being converted into taxable income while tax-disadvantaged income is being left unsheltered, says Gail Bebee, author of No Hype: The Straight Goods on Investing Your Money.
6. Holding speculative stocks inside a plan is not recommended. Advisers such as Pat McKeough, editor of the website Successful Investor, cite the risk of large capital losses, which can lead to a substantial reduction in the amount of capital benefiting from the “RRSP’s tax-deferral power.” But U.S. dividend stocks, which don’t benefit from the dividend tax credit, could be held in an RRSP. Their dividends would not be subject to U.S. withholding tax. Mutual funds with high distributions of taxable capital gains could be another candidate for inclusion.
7. The compounding of debt historically exceeds the compounding of returns on a balanced portfolio (at least on a risk-adjusted basis) over the course of the business cycle, argues chartered accountant David Trahair in his book Enough Bull. “Forget about RRSPs until your debt is paid off,” he urges.
8. But focusing on paying down a mortgage may be a mistake for people anxious about holding all their wealth in a house. An RRSP could be rationalized, in their case, on diversification grounds. Another error could be failing to contribute to a group RRSP when the employer matches contributions. And opportunities could be missed to reduce tax burdens by not using RRSPs to smooth volatility in taxable income over time periods.
9. A common stumble during the accumulation phase is not rebalancing one’s portfolio to an asset allocation appropriate to the investor’s risk tolerance; contributions are directed toward the investing theme of the moment instead of being used to top up lagging assets.
10. Some industry insiders, including Tom Bradley of Steadyhand Investment Funds, report encountering investors with dozens of mutual funds in their plans They are effectively tracking the market and would be better off in exchange-traded funds charging 0.2 per cent a year compared with the 2.4 per cent levied by the average equity mutual fund.
11. If investors are going to pay a premium for active investment management, says Mr. Bradley, they should own just a handful of mutual funds, and preferably those not engaged in closet indexing. Or hold a portfolio of 20 to 25 stocks.
12. A dollar of assets held in an RRSP is not the same as a dollar held in a non-registered account. Depending on tax rates, up to half of what’s in the RRSP represents deferred taxes. Not allowing for this difference may result in misjudging capital and asset mix.
13. Fancy moves such as leveraged meltdowns (getting money out of RRSPs tax free via transactions involving leveraged investing) and holding your mortgage in your plan can trip up with their costs, complexities and execution risks. Investors should tread very carefully.
Special to The Globe and Mail