Be Your Own Investment Manager Part 7: Understand RRSPs

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By Ed

Ahh retirement – a mythical time when days will stretch out before you waiting to be filled with whatever lifetime pursuit you have been putting off to your Golden Years. Travel, Leisure, Rocking Chairs all await you!

I don’t know many retired people, but those I do never say they have buckets of time or money. It seems that the idea of retirement is just that: an idea. Most people have a different reality than what they were expecting.

But I am not here to discuss retirement. Do what you like with it. I am going to concern myself with the single best (Canadian) vehicle for getting you there with a little more comfort: The Registered Retirement Savings Plan (RRSP).

No discussion of the RRSP would be complete without an explanation of why they exist in the first place. The Canadian Government in 1957 showed tremendous insight and foresight. Insight in that RRSPs allowed every Canadian, whether part of an employee-sponsored pension plan or not, to save for retirement AND reduce their individual tax burden.

What was the foresight? That the Canada Pension Plan (CPP) was not going to be able to provide for all Canadians forever.

Many people believe that the CPP is a pool of money they pay into, earn return on, then draw down when they retire. The first half of that is basically correct, but we don’t actually draw out our own money when we retire.

When you and I are working and paying into CPP, we really are paying for the people retired right now. Later on, when we retire, the workforce of the future will be paying for our Golden Years. It is truly more like an insurance program than an investment plan. Think Car Insurance: the accident-free drivers pay premiums that ultimately end up covering those who do have accidents.

The problem with this model is that it relies on more people working than being retired, just like car insurance relies on more safe drivers than bad ones. With the glut of baby boomers retiring now and in the near-future and the fact that lifespans are increasing (most people can expect to live 20 years longer now than they would have in 1940).

So, more retirees than ever, most of them living longer, means a CPP program that is stretched to the limits. The RRSP program was the solution to this. Nearly 50 years of foresight. Nice by any Government standard.

So, how does an RRSP get you fishing on a beach? How does it work? Does it have enough SPF to prevent the gentleman in the above picture from getting a sunburn on his head? We shall see.

When someone says they have their money invested in ‘RRSPs’, it is a bit like them saying their favourite TV program is a Show.

Everyone should really know what actual investment is inside your RRSP, because all the other steps (knowing your Risk Profile, Diversifying, Choosing Investments) could be hindered or compromised if you don’t. (And if you don’t know, you aren’t alone. In fact, you are likely in the majority).

An RRSP is not an investment in and of itself. It is more like a coat of paint or an Invisibility Cloak for your money and investments. Why is that? When your investments are inside an RRSP, the Taxman can’t see them.

How does this magical coat of paint work?

Any money you put into an RRSP is tax-deductible to a limit. This is the up-front carrot the government is giving you. Tax Deductible is good because the more money you make, the more you pay taxes on.

The RRSP lets you ‘hide’ some of that money now (when your tax bracket is higher) and then access it when you retire (when tax brackets tend to be lower). So – less income taxes now, more money later. Nice.

The amount you can deduct is based on a number of factors – your income, other pension plans you may contribute to through work – and has an annual maximum of $22 450 (for 2012 – the yearly Max. increases over time). Most of us also have unused space from previous years going back as long as we filed tax returns and didn’t max out our RRSP contributions.

Your contributions grow tax-free as long as you keep them in your RRSP. More good news – and a long-term carrot. All of our conversations about Compound Interest and getting time to work on your side rely on the fact that your money will grow untouched by you. If you had to pay taxes on your growth every year, it would hinder a great deal of the compounding.

You will have to pay taxes eventually. When you retire and start draining that money out of your Plan, you will be assessed at whatever your tax bracket is then. But like I said above, it is usually a lower rate. Good deals all around. Cayman Islands tax havens (kinda…) right here in Canada.

There are a few other rules to consider. Most investments are RRSP eligible, but if you are looking at a very exotic or foreign investment check here to see that it is, in fact, OK. You also need to turn your RRSP into something else (RRIF or an annuity) at age 71. I am glossing over these two items right now, as they won’t concern that many people right now.

The final things that people do want to know about usually are the Home Buyers plan and Lifelong Learning Plan. They are exemptions to RRSP withdrawals that allow you to get money early for very specific reasons (either buying a house to live in or going back to school). I can give you a very general answer to cover both cases, but like every general answer, there are exceptions to it.

My general answer: “Don’t Do It”.

People who take money out of their RRSP have to pay it back – this impacts your RRSP in a couple ways. First off – you kick your compound interest in the groin, right when it was about to get growing on you. Second, while you are scraping money together to pay back your RRSP, you are probably not contributing any more, so you are likely putting yourself several years behind in keeping up your contributions.

The cardinal rules for investing are start early and don’t touch the money. Home Buyers and Lifelong Learning break both rules.

But like I said, every rule has an exception. A home is an investment and property does increase in value, so if the home you are buying is the home you plan on living a long time in and seeing it grow in value, it might be less of a loss in the long run.

Also, if going back to school helps you get a much better job and earn a much better income, the minor hit to your RRSP will likely be more than made up for in the long run. But be careful – we all can talk ourselves into things that might not be the best for us. The HBP and LLP are big decisions and it may be in your best interest to talk to a tax accountant to fully understand all your options and the consequences.

So that’s it for now. It is RRSP season and I would be more than happy to field questions for the rest of the month and respond in Post, Message Board or email form.

I would also like to know what else financial you have questions about? RESPs, Tax-Free Savings accounts, other investing options or more detail in the things I have already covered/confused you with. There are no stupid questions.

I spent nearly a whole class one day going through (what I thought was) an amazing Mutual Fund explanation. When I was done, a young lady said, “I don’t get it.” “Which part”, I asked, hoping she could narrow it down to MERs or historical rates of return or something I had just finished with. “I don’t get any of it – what is a mutual fund?”.

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The “Be Your Own Investment Manager” Series: