If there is one financial planning message that has been drilled into Canadians it is this: "Be sure and try to maximize your RRSP contributions."
I believe that this is often good advice for people, but there are several cases where an RRSP doesn't make sense for someone – either for the long run or simply for a specific year. The key is that the RRSP is really a tax deferral and tax-sheltering tool. If you understand that, you have a better chance of determining whether it is right for you.
Here are five cases where it doesn't make sense:
1) You make less than $41,600 in taxable income. If this is the case, then you will receive a tax break of roughly 24 per cent or less for making an RRSP contribution. Because you will be taxed on every dollar when you eventually take money out of your RRSP or RRIF, you want to make sure that you are getting a high enough tax break for making the contribution. While most people don't know what their tax rate will be in retirement, in many cases, especially if your current income is low, your future tax bill will be equal to or higher than today's tax refund. In these cases, a TFSA is usually a better place to contribute any funds.
There are a couple of good calculators to help with this decision. One is at RetirementAdvisor.ca and the other is called simply RRSP or TFSA?
2) You will likely be making a much higher income in the next few years. Everyone knows that getting good investment returns is not a sure thing. But we can all agree with certainty that getting a 33-per-cent refund is meaningfully better than a 24-per-cent refund. When you build up RRSP room, the ideal scenario is to be able to maximize the refund on each dollar of contribution. Let's take a scenario where you are making $40,000 this year, but are very likely to earn $70,000 in the next few years (often due to unemployment or only working part of a year or a big promotion or new job). In this case, you would be better to contribute to a TFSA for now, and then put a larger amount into the RRSP in the year where your income is higher. Another option would be to put the money in your RRSP this year, but not claim the tax deduction until the year with higher income. The benefit of the TFSA contribution is simply more flexibility.
3) Money is really tight now. This is a simple fact of life for many people, however, many still feel compelled to put money into an RRSP every year. In most cases, the most expensive period for people is between ages 35 and 55, when they often have large family expenses alongside mortgage expenses. In some cases, annual expenses will drop in half or more from the time someone is 50 to the time they are 70. That doesn't include the inheritance money and house downsizing money that a 70-year-old is more likely to have than a 50-year-old. Why scratch away today to find some money for your future, when your future might be much more comfortable than your present. This is, of course, a risky strategy, but for many individuals it is in fact the proper course of action.
4) Pension plans at work provide matching or other contributions. In some cases, work pension plans cover all RRSP contribution room. In other cases, it covers some room, and there is an ability to top it up. Be sure and take advantage of any company plans where the company will match your contributions – whether it is a 100-per-cent match, 50-per-cent match or 25-per-cent match, it is still very powerful. If you have more matching room available to you with your company, be sure and use that up before making any extra RRSP contributions. The other issue at play when you have a good defined-benefit pension plan at work is that in retirement you will be forced to draw a certain amount of income whether you need it or want it. When it comes to certain government plans like Old Age Security, you might want to have more income flexibility in retirement. If you have a decent-sized RRSP as well a defined-benefit pension, you will be forced to withdraw a certain amount once it becomes a RRIF, on top of your pension. Having this income may mean that OAS benefits that you would otherwise be entitled to will get clawed back. For planning purposes, it may make sense in these cases to build up the TFSA rather than an RRSP, so that you can better control your taxable income in retirement.
5) You believe that you will likely be moving away from Canada some time soon. Unlike your luggage, the RRSP is not portable to other countries. If you have an RRSP, you must either leave it in place in Canada or close it up and pay a large one-time tax bill. For greater flexibility, you might want to start putting funds into a TFSA instead because it is much more accessible as you start a new life abroad. From a financial perspective it may still make sense to make RRSP contributions, but from a peace-of-mind and cash-flow-flexibility perspective, a TFSA often makes more sense.
As you plan the ritual RRSP contributions this month, be sure to think through whether a TFSA – or no contribution – might in fact be the better approach for your personal situation.
Ted Rechtshaffen is president and CEO of TriDelta Financial Partners, a firm that provides independent financial planning advice. He has an MBA from the Schulich School of Business and is a certified financial planner. He was vice-president of business strategy at a major Canadian brokerage firm.
Follow Ted on his blog at The Canadian Financial Planner.
For tips, stories, videos and live chats ahead of this year's RRSP contribution deadline, check the Globe Investor 2012 RRSP season section for daily updates.
Ted Rechtshaffen