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.

Mortgages: Fixed vs Variable (Wots....Uh The Deal?)

It isn't difficult to find a sea of information on this topic. Most leads to the conclusion that over an extended period of time one is always better off using a variable rate mortgage over a fixed rate mortgage. However, why do statistics show that eight out of ten mortgages are done on a fixed rate?

Am I missing something here???

I found a study done in 2001 at York University that concludes that over the period of 1950 to 2000 on a 15 year mortgage one would have saved an average of $20,000. That isn't pocket change. Three years later the same professor revisited the study given the climate at the time and came up with the same conclusion.

So what is it that is making so many people lock into fixed rate mortgages? The answer is emotional: stability. The idea of warding of the risk of any unplanned spike in the current interest rate. Generally people feel more at ease when they can sleep at night knowing what their payments are and what they will be over a given period of time.

However, let's explore some ideas associated with this 'stability'. Have a look at this. Another statistic showing past proof as to why variable is the answer.

Here's some other reasons:

I believe wealth is attained by proper planning and reducing the amount of money that goes to tax and/or institutions. One thing that is not often explored in the argument of fixed vs variable rate mortgages is the idea of 'front end loading'. Often this is a term associated with mutual funds. However, let's look at it in the context of mortgages:

Fixed rate mortgages are designed so that in the early years of the mortgage amortization the bulk of the payment goes towards interest. In the later years this payment reduces and becomes mainly principle. This means that the institution designs it this way to ensure that they are not only going to get paid first but also if you move your mortgage, refinance, or adjust your amortization schedule you will in a sense reset the front end load. The result of this is thousands of dollars over the life of your mortgage going to institutions and not into your own net worth. This compounds even more as we are seeing 30, 35, and even 40 year mortgages. Not only that but mortgage brokers get paid considerably higher on a fixed mortgage due to front end loading. Therefore consider that when taking advice.

One of the big reasons (not just money saved on interest) to explore with a variable rate is the fact that you only pay interest on what you owe. Why is this important? Variable rates are often up to one point lower than traditional fixed rates and float based on the present prime rate. This also gives you flexibility in your payment schedule. Take, for example, if you are doing a Mortgage Accelerator program. Every extra dollar that is put towards your mortgage in this scenario will result in a reduction of the interest component of your payment in the long term. Unlike a fixed schedule that predetermines the interest component for each payment of the term.

I will often tell people that one of the most important steps towards financial freedom is taking the steps to reduce the amortization time of their mortgage. Many do not realize the out of pocket money that is necessary to cover an entire amortization period and the money that can be saved be paying down the mortgage faster. Just that reason alone is enough for an average individual to take these steps. Not only that but the freedom to produce wealth, leverage your net worth, and take advantage of time becomes a major factor in looking at the positives.

If one could reduce that even more by choosing a variable mortgage over fixed rate why wouldn't they?

All the answers to all my questions come down one thing: risk vs reward.

A Part of All You Earn is Yours to Keep

Part of my goal with this blog is to show people how it is not difficult to turn existing financial plans into innovative and rewarding concepts that can maximize wealth, minimize tax, and maximize cash flow.

However, where does someone start when they are at the very beginning of their financial journey? It is always tough to take the first step.

One thing that is a fact about our habits when it comes to spending/saving habits of the average Canadian is that more often than not the majority of cash flow that we earn goes to someone else. The first thing that you might think of is the obvious: taxes, mortgage, debts, etc. However, consider the money that is going to entertainment, groceries, vacation, consumer spending, etc. It is all money that is making some entity other than yourself wealthy.

If there is anything left over than perhaps it may go into an RRSP or a high interest savings account for emergencies. More often than not emergency funds are liquidated for renovations, new cars, etc leaving you at square one. Not only that but most RRSP contributions are done at year end with what is left over. This doesn't usually amount to a significant savings.

Here is the concept I want to illustrate:

PAY YOURSELF FIRST

What does this really mean?? It means taking a portion of your income (let's say 10%) and put it away for yourself before the other people come to the door. More often than not you will see that you do have the cash flow to develop these rewarding habits.

These are basic concepts that build the foundations of authors like George C Clason and David Chilton

I have used the term dollar cost averaging in my blogs. This concept takes equal monthly contributions to the same investment regardless of cost. This way not only to you benefit from lows in the investment but you investment also grows on the highs. Wisebread has a 'for dummies' explanation here I highly suggest a read.

The point that I want to get across with the use of dollar cost averaging and the idea of paying yourself first is this:

While there may be better strategies and tools for you to save tax and grow more wealth, the habits that you develop in the early stages will help you recognize how to move ahead towards the future. You will be surprised how quick your investment will grow when fed properly.

Here is a quote directly from The Richest Man in Babylon:

"Wealth, like a tree, grows from a tiny seed. The first copper you save is the seed from which your tree of wealth shall grow. The sooner you plant that seed the sooner shall the tree grow. And the more faithfully you nourish and water that tree with consistent savings, the sooner may you bask in contentment beneath its shade."

Now if you are able to connect this financial concept to the concept of growing your financial knowledge along the way not only will you become wealthier but you will also become smarter with your money altogether.