What is the point of an RRSP?
A lot of people think that the point of an RRSP is to save for retirement, and that’s true. I mean it has ‘retirement savings right in the name!
Despite these registered accounts having cute little acronyms, they create a lot of misunderstanding.
In case you don’t already know, a registered account gives special tax-free or tax-deferred features. Sometimes, there are even free government dollars that get paid into the some of these accounts. Registered accounts include Registered Retirement Savings Plans (RRSP), Registered Retirement Income Fund (RRIF), Tax-Free Savings Accounts (TFSA), Registered Education Savings Plans (RESP) and Registered Disability Savings Plans (RDSP).
However, don’t be misled by the term ‘registered accounts’. Even if your account is not registered (for example, a regular trading or bank account), your trades and income are still reported to Canada Revenue Agency (CRA). This is done to prevent people from not reporting investment income on their tax return and pay tax on it. The CRA wants their cut of every dollar you make, and not just what you’ve earned with your own two hands!
When you put money into an RRSP, the CRA won’t charge income tax on the amount you added. For employees, this can result in a tax refund because your employer withheld tax on money the CRA says you don’t have to pay tax on. So, the CRA gives it back and that’s where your tax refund comes from.
It’s not that easy, of course. Like I said, the CRA will want their share of every dollar you make, but the RRSP is their way of letting you defer the tax to later in life.
Note that the key term here is defer, not prevent, reduce, avoid or waive. Deferring is probably good, right? Why pay now when you can pay later?
Did you know, though, that if you’re in the same tax bracket before retirement and after retirement, then deferring the tax makes no difference at all compared to using a TFSA?
If you can get the same after-tax return with a TFSA instead of an RRSP, then TFSAs are objectively better. They offer more flexibility of depositing and withdrawing funds without losing contribution room, and there is no tax consequence to doing so.
So why does anyone choose RRSP contributions over TFSA?
Well, high earners will be maxing out their TFSAs quickly as the current total contribution limit in 2023 is only $88,000. With the current RRSP limit at $30,780 per year, most people have much more RRSP room than they do TFSA, so they are using both.
Back to the point about deferring the tax, though. Most people are thinking short-term with their money and are thinking of getting a tax refund now. If they’re farther along in their financial education, they know that they’re trying to bring their income down to the next tax bracket by contributing to their RRSP.
But those with an advanced education are thinking ahead to when they plan to withdraw the funds, and they’re thinking of all the possibilities – they’ve practiced values-based spending for years to know what really matters to them and what their goals are.
The Worst RRSP Mistake You Can Make was made by someone whose earnings were accelerating rapidly. They were contributing to their RRSP throughout their career – a level, steady drip into the group plan. They’d used the Homebuyers Plan at one point to draw out $25,000 from their RRSP for their starter home, but they wanted to upgrade to a bigger home after a few years. The family was growing, and the kids needed a yard.
In the early part of their career, they’d been in 30-40% tax brackets as their income increased.
By the time they wanted to upgrade their home, they were well above the highest marginal tax rate because they were so successful in their career. That rate is 53.50%.
They didn’t have any TFSA’s – all portfolio contributions had been to RRSP’s. The starter home had appreciated in value, but not enough to afford the new home with the yard without some other source of funds.
Can you see yet what happened? What the mistake is?
They withdrew the RRSP money for the new downpayment at a higher marginal tax rate than when they contributed to the plan. That means they would have gotten 30-40% tax refunds on the money when they contributed, and then when they pulled the money out, they were taxed at 53.5%. On a $100,000 withdrawal at that tax rate, you’re giving $53,500 to CRA in income tax.
The question asked at the beginning of this article was, “what is the point of an RRSP”?
I’ll give you the answer. The point is to make saving for retirement easier by providing the potential to reduce your overall income tax rate over your life. It’s easier to save for retirement if you’re paying less income tax.
So, you need to be cautious about making sure that’s actually the way it’s going to work.
Was the Mistake catastrophic? No, of course not. Very few financial mistakes are hard to recover from (except disability or an untimely death). The family faced a big tax bill, but they were okay in the end.
How could they have avoided it?
They could have built up their TFSA savings over time as well, or deferred the purchase of the property.
And, they could have met with a financial planner before making the decision. That way, if they decide to go ahead with it anyway, they’re doing it fully aware of how it meets their goals and aligns with their values.
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