RRSP Season
Top 7 Mistakes to Avoid when using Registered Retirement Savings Plans (RRSPs)
Executive Summary
• Registered Retirement Savings Plans (RRSPs) are a critical part of any long-term financial plan
• RRSP contributions need to be made by March 1, 2022 to be eligible for the 2021 tax year
• There are common themes and practices you can follow to effectively use RRSPs, and avoid costly mistakes
• Making regular contributions, and managing cash flow so you avoid penalties or interest costs maximizes your returns
• Be intentional with each action you make to avoid unwanted tax impacts
Introduction
Well it is here! RRSP Season. Registered Retirement Savings Plan (RRSP) contributions need to be made by Mar 1, 2022 to be eligible for 2021 tax returns. You may be asking, why you need to make contributions, or what benefit there is by doing so. Put simply, an RRSP is an account that allows you to “shield” current year income thereby reducing your tax bill, and the savings grow tax-free, until you start withdrawing the funds in your retirement (at age 71 the RRSP converts to a RIF – Registered income fund). This is critical to letting you build your retirement nest egg. The remainder of this article will focus on common mistakes that are made when using RRSPs.
Mistake #1: Over-contributing to your RRSP
The Federal government allows for RRSP contributions for the lesser of 28% of 2020 income, or $27,830 for the 2021 tax year. If you contribute more than this amount, you will pay a penalty of 1% per month on the excess contribution until it is removed from the account; it will also not have any tax benefit so its essentially “dead money”. Note that there is a lifetime overcontribution "grace" of $2,000 (no penalty, but also no tax benefit), but to be quite frank, I would not recommend putting this to the “test”!
Mistake #2: Making Early Withdrawals
The primary downside to RRSPs, is that once contributions are made, the only way to remove money from the fund (prior to retirement) is with a 30% withholding tax. I will say it again - a 30% withholding tax on any amount over $15,000! Any withdrawal between $5,000 and $15,000 would have a 20% withholding tax, while any withdrawals less than $5,000 would be taxed at 10%. Even more concerning than this, is that you permanently lose the contribution room. This mistake will add up to hundreds of thousands of dollars over decades – it is not prudent to manage you funds in this way. Note: There are two unique situations where you can withdraw from your RRSP, essentially creating an interest free loan to yourself: the Lifelong Learning Plan (LLP), and the Home Buyers’ Plan (HBP) – check out more on the HBP in our December Blog Post.
Mistake #3: Not Investing Contributed Funds
After you contribute to your RRSP, you need to be sure you invest the cash – otherwise it won’t grow! While having some cash on hand is an effective investment strategy so you can capitalize when there are downturns in the market, not investing any contribution is very bad. Investments are all about risk-reward, and just holding cash has no risk, so therefore no reward. The primary benefit of an RRSP is that your funds can grow TAX-FREE, so if you are just leaving cash in the account that entire benefit is gone. You would be equally well off holding the funds in a basic bank account (you would be able to access the funds at any point without being taxed in this case too).
Mistake #4: Not Using Spousal RRSPs (if Married)
For those who are married, Spousal RRSPs are a great way to help set yourself, and your spouse up for retirement. To set up Spousal RRSPs correctly, it should be established in the lower-income spouse’s name. The higher-income earner can then shield current income by contributing it to the lower-income earners spousal rrsp. At retirement, the RRSPs for the two spouses can then hold roughly equal balances (if spousal contributions are done properly), thus balancing post-retirement income and lowering the tax burden, making funds go further. While the Spousal RRSP doesn’t create additional contribution room (it would still be 28% of total income for the couple), it does allow for significant tax benefits, especially in retirement, provided accounts are managed appropriately.
Mistake #5: Not Utilizing TFSAs
Personally, this is one of the primary items of caution for clients I work with, and something I practice personally as well. While RRSPs have many benefits, I personally rank TFSAs higher on the priority list (ie) if I have $100 to invest, and room in a TFSA or an RRSP, I would invest it in the TFSA). The primary reason why I contribute to the TFSA first (provided there is contribution room), is because I can then access the funds whenever I’d like. While the RRSP would be beneficial for anyone looking to save for retirement and helps force discipline (as you can’t take the funds out without major tax implications – see point #2 above), if you maintain financial discipline, having the flexibility of the TFSA is more important – what if you buy that retirement property early? Vacation home to rent out? This can’t be done if the funds are locked into an RRSP. The main caution I would make, is that you have to ensure you do save for retirement if you are taking funds out of the TFSA, and if you struggle with disciplined investing, it may make sense to use the RRSP and lock the funds in until retirement (and get added tax benefit now!). If you’d like to discuss this point in more detail, please do not hesitate to set up a free consultation (Click “Book Free Consultation” in the top righthand corner!).
Mistake #6: Having to Take a Temporary Loan to make Contributions
This strategy works like this: Contributions are required but you don’t have free cash to invest, you take out a temporary loan and use the proceeds for your RRSP contribution(s), you then repay the temporary loan as able (most people repay the loan when they get their tax return back 2-3 months later). While this strategy does make sense from a practical standpoint, the reality is that there are additional interest costs that wouldn’t exist if your cash flow had been managed appropriately through the year. It is a sign of poor cash flow and budget management. To counteract this, we would stress to you the importance of having a monthly budget with RRSP contributions setup as a budget line item, and it reviewed frequently so you monitor your cash and make the required contributions through the year. Additionally, you could setup monthly contributions directly from your pay cheque (or bank account) to your RRSP, thereby eliminating any risk at “crunch time”. No Loan = No interest = more money for YOU!
Mistake #7: Not Capitalizing on Employer Match Programs (RRSP or Pension)
Most employers offer some kind of RRSP or Pension contribution match program. This is where you voluntarily contribute to an RRSP or pension fund, and then your employer matches that contribution – typically on a 1:1 basis. I have never found an investment that offers a 100% return, year-after-year, with zero risk. I promise you, there is NO BETTER INVESTMENT. Given this is also a part of your compensation package from the company, you HAVE to make this happen. I hope everyone would agree that they wouldn’t take $5-10K less in salary – VOLUNTARILY!! Similar to managing mistake 6 properly, you have to find a way to manage your cash flow and take advantage of Employer Matching programs. If you don’t, you will be costing yourself hundreds of thousands of dollars in the long-term!
Key Principles and Guidelines
To summarize the key principles and points we discussed above, there are three main guidelines to follow:
1) Make regular contributions to your RRSP (helps to avoid overcontributing or not contributing, taking advantage of employer match programs, as well as investing for long-term gains).
2) Manage your cash flow appropriately (Avoids being forced to take temporary loans, or face stiff early withdrawal withholding tax “penalties”).
3) Ensure you know the tax implications of what you are doing (Spousal RRSPs, early withdrawal penalties, ensuring TFSAs are used appropriately)
If you follow those three principles when using your RRSPs, you will be well on your way, and set not only yourself but your entire family up for success in the long-term. WOOHOO to that!
Happy RRSP Season – see you next month when we delve into the top reasons to buy a home!
