13. Is an RRSP the best choice for your retirement savings?

Transcript:

Hello and welcome back to the Canadian Money Roadmap podcast. I'm your host, Evan Neufeld. On today's episode, we are going to be talking about registered retirement savings plans or RRSPs. I'm going to talk about a brief overview of how they work, a few myths about typical usage, and then explain at the end a few ways to make sure that you use an RRSP to your advantage. 

So as a basic overview of how an RRSP works, is that when you make a contribution to an RRSP, which again is kind of like a bucket. If you go back to my TFSA episode, I talk about a TFSA being a bucket, an RRSP is also a bucket. It's not an investment in and of itself. So when you make a contribution to your RRSP bucket, you receive a tax deduction for your contribution.  Depending on what your marginal tax rate is, you'll get a greater or smaller refund based on your current marginal tax rate. So you have a maximum contribution of 18% of earned income, plus any accumulated room from previous years. There's a maximum per year, but you can kind of stick with the assumption of 18% of your income. 

Then once your money is invested, taxes owing on things like dividends, interest, capital gains, or whatever is deferred until you make a withdrawal from the plan. So an RRSP is a tax deductible contribution plan, and it's also a tax deferred plan because you won't pay any taxes on any investment income inside of the plan until you make a withdrawal. 

So just because it has retirement in the name, you can actually make a withdrawal at any age, not just retirement.  But whenever you make your withdrawal from the plan, a hundred percent of it is taxable, regardless of whether it was your original contributions, dividends, interest, capital gains, anything like that, every dollar you take out of the plan is fully taxable. 

So now that we have a basic understanding of how an RSP works, I'm going to talk about a few myths or misunderstandings about how RRSPs are typically used and hopefully try to steer you in the right direction. So the number one myth that people assume is that an RRSP purchase is made with pre-tax money, which means that you're investing a larger sum and then your RRSP bucket, by the time you retire, will be worth a lot more which it has to because when you withdraw from it, you owe taxes on it as well. The idea that people often think is that, okay, well, I'm going to have a big RRSP pot of money from which to withdraw my retirement income from. 

However, if you look at your paycheck, most people are actually paid with after-tax money. Meaning their employer sends some tax to Canada revenue agency for you. So what you're really doing when you make an RRSP purchase is you're investing after tax money. You wait to file your return. You wait to get the refund, then you have to have the discipline to actually invest the refund. Otherwise the money that's in the plan remains just after tax money. The problem is that no one invests the refund. I'm not going to say no one, but it is highly unlikely that the average person is investing their refund back into the RSP plan. 

Why? Because it's so easy to spend money that comes back from the government. it, it feels like a bonus. 

However, if you are contributing to an RRSP with after tax money, that refund that you get actually needs to be reinvested or else you're creating a tax problem for your future self. So if you're investing after tax money and then spending the refund, you're really only investing after tax money. And you would have been way better off in a tax-free savings account, because once you're investing after tax money, you want it to be in a place where it compounds the most tax efficient way as possible. 

 Myth number two, purchasing investments in an RRSP is a way to pay less tax. Okay. In theory, this is kind of correct. However, an RRSP shouldn't be used as a tax minimization strategy. It should be an investment maximization strategy. Let me clarify this a little bit more. So when you make your contributions to an RRSP, it is tax deductible in the year you make the contribution. You can carry forward contributions if you don't want to claim them all, but that's another minutiae that I won't get into right now. but. If you get a tax deduction in the year, you make your contribution. People think great an RRSP is a great way to pay less tax. 

However, the biggest advantage to investing your money is compound growth over time. And the power of compound growth works against you if it's in a tax inefficient account. So if you're taking after tax money, making a contribution and spending the refund. Now you have after tax money, compounding against you in a taxable way. 

Yes, it's growing, but every dollar that it's growing by becomes a hundred percent taxable when you take it out. So ideally, like I mentioned at the beginning, it should be an investment maximizations strategy. So when you get your refund, make sure that you are investing that refund.  

Myth number three, if you're saving for retirement, everyone should be using an RRSP. Just because it has retirement in the name, a lot of people think that the RRSP is the way to go. And for people that have been investing for many, many years an RRSP was actually the only game in town. They have been around for much, much longer than the TFSA has. 

So for a while, an RRSP was the best option because it was really the only option for a tax deferred investment plan. However, now that we have some other options to pick from, we have to make sure that we're choosing the right account for our current situation. 

One strategy that people often talk about when using an RRSP is that they're going to contribute at a high tax bracket and withdraw in a low tax bracket when they're in retirement. In theory, this is a good idea too. However, where people think that they're in a higher tax bracket than they really are, but I'll get to that in a second here again. 

So if you are in a situation where you actually are in one of the higher tax brackets and you have the discipline to reinvest the refund. That might be a good example of using an RSP for retirement. But if you're going to be in the same tax bracket, when you contribute and you withdraw, you still have to have perfect discipline to reinvest the refund or else you would have been better off in a TFSA. 

I've gone off track here a little bit, but one of the last myths that I'm going to talk about is that you're going to be in a lower tax bracket when you retire.  I alluded to this one briefly already, however, many people think that they are currently in a much higher tax bracket than they really are and then when they retire, just because they won't have employment income, they think they're going to be in a lower tax bracket.  Many times this isn't actually the case and in some scary scenarios, you might even be in a higher tax bracket in some of the early years of your retirement than when you made some of your contributions. 

This is the absolute worst case scenario where you give the government additional tax money. Based on the compounding of your investments and the time that you spent investing  that money, the difference say you contribute at 25% tax rate, and then you withdraw it in a 33, that is giving the government free money.  It's possible, not super likely, but definitely possible.  

This is why you want to make sure that you're contributing in a tax rate where you have the greatest chance having the difference of marginal tax rates work in your favor, meaning you actually need to be in a higher tax bracket when you make the contribution. 

So talking about tax brackets briefly here. Many of my listeners here are in Ontario and the middle tax bracket that we often refer to in Ontario is about 49,000 to 80,000. And we pay about 30% tax rate. Then here in Saskatchewan. It's between 49 and 98,000. And we pay a third. So 33% of that income in that bracket. 

So stick with me for a second here. So say you're earning $90,000 in Saskatchewan. If you retire, you could have almost half of the taxable income in retirement and still be in the same marginal tax bracket of 33%. 

Your average tax rate will be quite lower. However, your marginal tax bracket will be higher. So there is a chance that you won't actually receive much in the form of tax savings. 

When you look at taxable income in retirement, a lot of people forget that government benefits like CPP(Canada pension plan) and old-age security(OAS), those are all taxable sources of income that are outside of your control. And so many people will actually have about half of their taxable income coming from places outside of their savings. 

So if they had saved diligently inside an RRSP. And then when you start taking the money out, in addition to your government benefits, you might not have to actually withdraw that much money to stay in that middle tax break.  

So if you were thinking about making an RRSP contribution, have a look at your actual tax bracket and not just assume you're in a high bracket, because you've got a rate raise recently where you make more than your friends. That's a big misconception that a lot of people have. So take a look at your province, take a look at what your tax bracket is. The greatest chances of success with an RRSP is if you make a contribution, when you're in a marginal tax bracket that's higher than the one that you're more likely to end up in, in retirement. My rule of thumb is that if you are making more money and you're in the marginal tax bracket, that's higher than the middle one in your province that might be a good place to start. 

 Then the second part of this myth is your tax bracket in retirement. In the first few years of retirement in particular, what do you think that most people do? What would you do? You're probably going to want to travel. If you have grandkids, you might want to spoil them a little bit. 

I see many, many times a big family trips and it's often to expensive places like Hawaii or Disney world or whatever.  Many other people will buy an RV, or they go into retirement with a new vehicle, things like that. And so if most of your sources of income that you need for these large purchases or additional spending are all taxable, your taxable income, especially in these first few years of retirement might actually be much higher than you anticipate. [And I would go out on a limb and say that you're probably going to end up in at least that middle bracket. 

Now that I've talked about a variety of the ways that you can do things wrong with an RRSP. Here's a few ways that you can actually do things right with it RRSP. So if you have a group plan at work, meaning your employer makes some contributions for you, you're actually able to make pre-tax contributions because your employer is the one that gives you the money. 

And they're the ones that withhold tax for you at the source to send a CRA in advance for you. So if they make a contribution on your behalf, then you're actually investing pre-tax money and you don't need to have the discipline to re-invest your refund. Okay, so half of the hard work is done for you so that's a good place to be. Secondly, if you have self-employment income, you're the one that made the income. So you haven't actually had to send any to CRA in advance. Sometimes you might have quarterly payments or things like that, but self-employment income is another way to make sure that you are investing pre-tax money and you don't have to have the discipline to reinvest the refund. Because most self-employed people don't have a refund because they actually have to pay tax at the end of the year. So being in a situation where you can truly invest pretax money without the discipline to reinvest the refund is a really good place to start with an RRSP. Second one, I've alluded to this a few times already, but if you're in an income bracket, that's higher than the middle bracket of your province, you have a higher chance of success by using an RRSP. 

The idea is that you want to contribute in a high rate, withdraw from a low rate and it's nearly impossible to do that if you're contributing from the upper end of the middle bracket. So here in Saskatchewan, again, say you're making 95,000. The chances of you actually dropping a tax bracket in retirement are very, very low.  So you want to be in the lower parts of your current tax bracket to have the greatest chance of success of actually being in a lower tax bracket when you retire. 

So to summarize a few of the myths here, number one in RRSP purchases made with pre-tax money. No it's usually made with after-tax money. You have to file for your tax return. You have to wait for your refund and have the discipline to reinvest a refund. So just be very, very careful when you're making your assessment between an RRSP and at TFSA. Especially when you're looking at analysis, the global mail, maybe the wealthy barber, maybe some blogs or maybe an Instagram post, you will not have a larger RRSP pile of money unless you have reinvested your refund or you actually have the capacity to invest pre-tax money. The problem is most people don't have that option to invest pre-tax, so make sure you understand what types of contributions you have so that you can make a real assessment of whether an RRSP or a TFSA is best for you.  

Second, purchasing investments in RRSP as a way to pay less tax. Yes, in theory, but over time, if you want to keep your lifetime tax bill low, an RRSP might not be the best way.  So ideally an RRSP shouldn't be a tax minimization strategy. It should be an investment maximization strategy. 

Three, if you're saving for retirement, everyone should be using an RRSP. No, not necessarily. There's a very specific situation where we'll have it increased odds of success using an RRSP, but it is not for everyone. 

And number four, you're going to be in the lower tax bracket when you retire, who knows? You don't necessarily know that and if history is any guide, most people in Canada spend a lot of money in their first few years of retirement in particular,  so you may not actually be in a lower tax bracket in retirement or as low as you might think 

In conclusion, make sure you know what your current marginal tax bracket is, how much you have available to save and then you can really do a good assessment of whether an RRSP or a TFSA is the best option for you. If you struggle with discipline, especially when you receive a tax refund, a TFSA might be a good option. 

However, if you really struggle with discipline and you want to withdraw your TFSA money, because it's available and there's no immediate penalty for it. Maybe the RRSP is a better option for you. Now I've complained a lot here about how people often misuse an RRSP, but I'll maybe scale that back a little bit for a second here.  Even if you're doing it wrong, by investing at the wrong time, in the wrong tax bracket and spending a refund. 

If the immediate tax benefit or tax savings in the year, you make your RSP contribution is enough of a carrot to make the investment in the first place. And that's the only thing that will actually get you to invest some money for the long-term. That's a better option. That's a better option than saving nothing at all. So I would much rather you do it wrong and save some money for an RRSP, but I hope that most people listening today are those who want to make sure that they're making the best decision, not the bare minimum.  Since an RRSP is best used under a very specific scenario, I would recommend that you look for some advice or a second set of eyes. So you make sure that you're making the decision that's actually best for you.  

 Thanks for joining me today on the Canadian Money Roadmap Podcast. If you enjoyed today's episode, I'd really appreciate if you left me a review on Apple podcasts with your biggest takeaway. If you have questions or ideas for topics you'd like me to discuss on future episodes, please reach out via my contact info in the show notes. 

This podcast is intended to be educational in nature, and you should always consult your financial, tax and legal advisors before making changes to your financial plan. Any rates of return discussed are historical or hypothetical and are to be used for educational purposes. Evan Neufeld is a Qualified Associate Financial Planner and Registered Investment Fund advisor.   Mutual funds are provided through Sterling Mutuals Inc.