It’s RRSP season again, the time of year when banks and other financial institutions do everything possible to cajole you to deposit some money with them. Don’t be in too quick a rush to do so.
Don’t get me wrong. I have nothing against RRSPs – far from it. My 2014 book, RRSPs: The Ultimate Wealth Builder, sums up my views about registered retirement savings plans. They are potentially huge money-making machines, but only if set up properly and managed effectively.
That’s not easy. You have to do some research and develop a suitable investing strategy. But if you are willing to spend the time to do that and start early enough, it’s feasible to build a plan worth more than a million dollars at age 65.
Here are some suggestions for setting up a successful plan. Older readers may want to share these tips with their children or grandchildren.
Decide between an RRSP and a TFSA
Both are excellent savings plans but with different dynamics. An RRSP deposit is tax-deductible, one made to a TFSA is not. But withdrawals from an RRSP are taxed at your marginal rate whereas TFSA withdrawals are tax-free.
For long-term retirement savings, I would choose an RRSP. For starters, you can contribute more. The maximum TFSA contribution this year is $6,000, plus any accumulated unused contribution room. With an RRSP, for the 2020 tax year you can contribute up to 18 per cent of 2019 earned income to a maximum of $27,230 (again, plus any previously accumulated room). That’s a huge difference. It may not mean a lot if your salary is low in the early years, but as your income increases over time, the difference in contribution limits will become significant.
Another reason to choose an RRSP is the tax on withdrawals. It’s a huge disincentive to pulling money out of a plan unless there’s a desperate need. TFSAs make it too easy to get at your retirement savings. The longer the money accumulates tax-sheltered, the richer you’ll be.
Choose the right plan
There are several types of RRSPs, from high-interest savings accounts to full-service brokerage plans. Opt for maximum flexibility. Find out exactly what securities the plan is allowed to hold, and what is excluded. For example, your local bank may offer a plan that allows you to invest in their mutual funds but not those of other financial institutions. A brokerage account with an online company will usually provide the best combination of flexibility and minimal costs.
Start early
The longer the money is left to compound in a tax-sheltered plan, the greater the final amount will be. For example, let’s consider a 20-year-old who opens a plan with $1,000 and contributes that same amount each year until age 65. Her average annual compound rate of return is 6 per cent. At age 65, the plan will be worth $212,743.51, according to Royal Bank’s Retirement Savings Calculator. If the same person started at age 30, the final total at 65 would be $111,434.78. That delay ends up costing more than $100,000 in savings.
Manage the deductions
Many people believe you have to claim RRSP deductions for the same year the contribution was made. That’s not true. Just as unused RRSP contribution room can be carried forward, so can your deductions. This is especially useful for younger people at the start of their working careers who are in a low tax bracket. Those whose income was hit by the pandemic in 2020 can also use this rule.
To give you an example of how this works, consider an Ontario resident who started an entry-level job in 2020 and earned $35,000. According to the EY 2020 Personal Tax Calculator, he would have a marginal tax rate for the year of 20.05 per cent. Claiming the tax deduction for an RRSP contribution would be worth only 20 cents on the dollar.
But let’s assume he works his way up in the company and five years from now is earning $60,000. Assuming no change in the tax rate (a big assumption, I know), his marginal rate would be 29.65 per cent. If he claimed his accumulated deductions at that point, they would be worth almost 30 cents on the dollar.
So, if you’re in a low tax bracket, keep your deductions in reserve.
Set up an automatic contribution plan
One of the most-used excuses for not making a contribution is lack of money. That’s not surprising, with the holiday season bills still coming in. Get around that problem by setting up an automatic contribution plan. Ask your employer or your bank to direct a specified amount to your plan every month. That way, you won’t be scrambling when the next RRSP season comes around.
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Gordon Pape