Max out your RRSPs! This is what everyone will tell you. You don’t pay any taxes on anything you put in an RRSP so you should take advantage of it as much as possible, right?
As I’ve mentioned before, first you need to figure out how much you can afford to save, then come up with a balanced plan based on your goals, then decide on the best investments for you. RRSPs should play a part of that plan, but they should never be 100%, even if your RRSP portfolio is balanced.
(Sidebar: I find people get confused about what an RRSP account actually is. The truth is, most investments can be designated as RRSP accounts, but an RRSP isn’t a thing. You can’t put money in an RRSP. You can buy index funds, mutual funds, stocks, bonds, or put your money in a savings account, to name a few. Then you tell the company that you invested in, that you want those investments designated as RRSP investments. All that means is that they change their administration of those accounts. Now, they have to report them to the government under your SIN and name and the government will agree that you don’t have to pay income tax on that invested money, nor do you have to pay tax on any income those investments generate.)
Why shouldn’t you max out your RRSPs? Let’s look at a simplified example:
Joe makes $100,000/year and he decides to invest his maximum amount per year – $18,000 or 18%. Assume Joe makes this every year for 40 years at 6%. Joe starts at 31 and does this every year until he has to convert his RRSP to an RRIF at 71. Joe also retires this same year. Also, forget about inflation for the purpose of the example, because it’s confusing.
Joe turns 71 and has $3,000,000 in his investments designated as RRSPs. He transfers the $3,000,000 to an RRIF, as is required by the law, but his investments pretty much remain the same. The only difference between his RRSP and RRIF is that he is required by law to withdraw a minimum amount from an RRIF. The minimum amount at the age of 71 is 5.28%.
Before we continue, let’s congratulate Joe on being awesome. He saved for 40 years and has $3,000,000! Good for you Joe!
Joe decides he doesn’t need the full $100,000 he was making for 40 years, mostly because his house is paid off and his everyday expenses are a bit lower. He’s good with $60,000 a year. That’s all Joe wants. Any more money than that would end up right back in the savings. Also, making only $60,000 a year, he finally gets to pay less tax – forget you, tax man!
(Ok, this next part is hard, as I don’t want to upset Joe, after he followed the “max out your RRSP” rule for so long, so let’s just rip off the bandaid real quick…)
After the RRIF is set up Joe gets a letter from the CRA telling him that 5.28% of $3,000,000 is $158,400 and that’s how much he has to withdraw from his RRIF. And that’s how much he’s going to make this year(let’s ignore CPP and OAS please so Joe doesn’t have a heart attack), and he’s going to have to pay taxes on that.
So, this is Joe’s reward for his diligent savings:
- He’s forced to withdraw $58,400 MORE than he was making before he retired
- He’s forced to withdraw $98,400 MORE than he actually needs to live today
- HIS TAXES ARE HIGHER THAN THEY WERE WHEN HE ORIGINALLY SAVED THE MONEY
So Joe followed the rules and maxed out at 18% a year but the result wasn’t what he anticipated.
What could Joe have done differently?
A RETIREMENT PLAN CAN STOP YOU FROM SAVING TOO MUCH MONEY
If Joe would have sat down at the age of 31, with a personal finance coach, and created a financial plan, he would have seen how much his $18,000/year would get him over 40 years.
He would have realized that he didn’t need $3,000,000 at the age of 71 and that he would be forced to take out too much money and pay a lot of tax, something that he promised himself he would never do.
Sometimes we get so caught up with following the rules that we don’t actually stop to think about whether they apply to us. We save all this money because someone tells us it’s the right thing and maybe it means we go on less vacations during our prime activity years.
$9,000/year would have been more than enough over 40 years at 6%. Joe would have had around $1,500,000 and then his minimum withdrawal would have at least been less than his $100,000 salary.
The key is to find the balance between saving and spending. A financial plan can help you figure out how much to put away and how much to use to live your life today.
But should all your savings be designated as RRSPs? Stay tuned for a future post on that topic!