Are RRSPs Right for You?

Today I will be speaking on CFRA in Ottawa from 3-4. To listen live click here.

What is going to be discussed on the program is RRSPs and if they are right for everyone. I had touched on this earlier in my Living In Canada post in regard to how this would specifically effect the Ottawa population.

The main points that I plan to cover in the program are:

1. Is it possible to have too much in an RRSP?
2. The positives and negatives of RRSPs
3. Are RRSPs for everybody?
4. The 'RRSP Freeze'
5. The 'RRSP Meltdown'

1. Is it possible to have too much in an RRSP?

Yes.

How do I know if I have too much in my RRSP? Well, let's look at a common scenario:

John is 55 and plans to retire in 10 years. His retirement plan is to have an annual income of $50,000 (in todays dollars) to meet needs during a 25 year retirement. This means that John will need in the area of $900,000 in his RRSP to meet these needs on an after tax basis (assuming an average return of 8% and inflation of 3%).

Here is the problem: John has invested well and accumulated in the area of $600,000 in his RRSP already. Assuming he doesn't make one more contribution his RRSP will have grown to over $1.2 million by age 65. This leaves him too much in his RRSP.

Why is this a problem? Since an RRSP is a tax deferral device every dollar that John takes out is taxed at his marginal tax rate as income. Not only that but any assets left in his RRSP at the time of death will either be rolled to his spouse or all taxed in one lump sum to the government. In the end Ottawa is likely to receive nearly half of his savings.

2. The positives and negatives of RRSPs

For anyone who is paying tax an RRSP is easiest way for someone to save and receive a tax deduction at the same time. I have also noted before that if it weren't for this vehicle many people would not have saved at all. Therefore it provides the discipline needed for many people to save. At the same time your money has the ability to grow on a tax deferred basis which allows time and compounding growth to effectively work on your investment.

For those reasons I do not abandon the belief in the RRSP entirely.

However, let's look at the negatives. I have noted one above. The tax bite that is taken when you use the assets built inside your RRSP. For some this could lead to higher taxes and/or claw backs of government benefits.

Another negative is government control. Since your money is considered to be registered you have to follow the rules that the government imposes on you. This leads to investment control, contribution control, and withdrawal control.

3. Are RRSPs for everybody?

That comes down to a case by case basis. However, numbers will prove that by using tax deductible vehicles in non registered investments(such as conservative leverage) and taking advantage of Canada'a capital gains exemption that investors are likely ahead with this method.

However, let's assume that someone does utilize the strategy of conservative leverage (borrowing to invest) as an alternative to RRSPs, certain risks have to be addressed. Not only that, the investor has to be a likely candidate to qualify for such a program. Risks vs rewards in this situation have to looked into deeply to see if it is the right strategy for you.

If it isn't than RRSPs are likely an excellent vehicle for you. Many people are beginning to recognize the value to utilizing both strategies.

4. The 'RRSP Freeze'

So let's assume that you may be thinking that you have too much in your RRSP. What should you do?

First thing is to stop contributing. Start working on a plan to invest outside of your RRSP. This is not to be done because you no longer believe in the vehicle itself but rather that you now recognize that it may not be the best place for your money as you approach retirement.

If you are in a lower tax bracket or if you see that you are not going to use all of your assets in your lifetime consider taking the tax hit now and reinvest in a conservative non registered investment subject to capital gains. In the long run you will save a lot on tax.

5. The 'RRSP Meltdown'

Let's revisit John's situation.

Now that John has realized that he has too much in his RRSP he has done an RRSP Freeze. The next step would be to consider an RRSP Meltdown.

Instead of contributing to his RRSPs John has taken out an investment loan at 7% interest for $100,000 in high quality, conservative mutual funds. John makes interest only payments on the loan for $7000 annually for which he takes $7000 out of his RRSP to cover.

Since the payment for the investment loan is tax deductible and the withdrawal from the RRSP is taxable he ends up net no tax at the end of the year. The interst deduction offsets the taxable RRSP withdrawal so that he is effectively not taxed on the RRSP withdrawal.

Not only that but the non registered investment, given time, will grow to produce much more tax efficient wealth subject to capital gains. Therefore, 50% of his growth is now tax exempt. John just saved a lot of tax.

Check out some opinions on this strategy from Garth Turner and Tim Cestnick 1, 2.