- The RRSP or registered retirement savings plan.
Is a special type of account in Canada
that gets special tax treatment
from the Canada Revenue Agency.
It is only an account.
The RRSP itself is not an investment.
For any of my U.S. audience
the RRSP is similar in many ways to the traditional IRA.
The RRSP was first introduced
in 1957 at a time when defined benefit pension
plans were still common.
Since then defined benefit
Pensions have mostly disappeared
and Canadians are largely
on their own to save for retirement.
The RRSP is one of the most helpful retirement
planning tools that we have available to us
for two main reasons.
It allows us to, to defer income tax to a future year
and it allows our investments to grow tax free.
I'm Ben Felix associate portfolio manager at PWL Capital.
In this episode of Common Sense Investing.
I'm going to tell you everything that you need to know
about the RRSP.
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There's a lot to cover on this topic.
So I'm going to try and break it
up into a few sections that I think make logical sense.
First, I'm going to tell you how the RRSP works.
Then I'm going to tell you the most
common misconceptions that I see when it comes to the RRSP.
And finally, I'm going to tell you how to think
about the RRSP in context of your investment portfolio.
Each year that you have earned income,
you get 18% of the amount that you earned
added to your RRSP limit
for the following calendar year.
Earned income is a bit
of a broad definition.
The most common sources
of earned income are T4 employment income.
Which you would have as an employee.
Net self-employment income.
Or net rental income.
For example, if you made $100,000 in 2018
your new RRSP room in 2019 would be $18,000.
There is an annual maximum for new room.
In 2019 the maximum is 26,500.
Which means that if you earned more
than $147,222 in 2018, you would not get additional RSP room
on the additional income.
Everyone gets $2,000 of over contribution room
on top of whatever their limit is.
Any excess contributions though cannot be deducted
from your taxable income.
If you pay into a pension plan or deferred
profit sharing plan, then your RSP room
will be reduced based on those contributions.
Once you have contribution room,
you are able to make a contribution.
Here is where the RRSP starts to get interesting.
Every dollar that you contribute to the RRSP
within your deduction limit.
Can be deducted from your taxable income
in that year or in a future year.
That last bit is really important.
You do not have to deduct the full amount
of your contribution in the year that you contribute.
Can you guess why you might not deduct all
of your contributions in a given year?
You might consider deferring some or all of your deductions.
If you expect to more income in higher tax brackets
the following year.
In order to do deduct your RRSP contribution
from your income in a given year.
The contribution has to be made
within the first 60 days of the following calendar year.
For example, if you want to use your deduction
for the 2018 tax year.
Then your contribution has to be in your RRSP account
by March 1st, 2019.
The RRSP is referred to as a tax deferred account.
You defer income tax
by using your RRSP deduction to lower your taxable income.
When you eventually withdraw from the account,
the withdrawals are included
in your taxable income at that time.
At age 71, the RRSP has to convert to a RIFF,
which has a minimum annual withdrawal.
In other words, at some point in the future
you are required to start making taxable withdrawals
from the account.
There are a couple of cases where money can be taken
out of the RRSP without incurring
an immediate tax liability.
The Home Buyers Plan allows
for a first-time home buyer to withdraw up to $25,000.
You are considered a first time home buyer.
If you did not occupy a home that you or your current spouse
or common law partner owned within the four year period
beginning on January 1st of the year
that you will withdraw funds from the RRSP.
When you make a Home Buyer's Plan withdrawal
you have to pay it all back into your RRSP
over 15 years, starting in the second year after the year
of the withdrawal.
If you miss a repayment, it is treated
as if you withdrew that amount as taxable income.
It's kind of like a loan to yourself
where you're borrowing out of your RRSP.
The Lifelong Learning Plan shares similar properties
to the Home Buyers Plan,
Except that the amount is $10,000 per year
up to $20,000 total.
And the purpose is for covering education costs.
And the repayment period is 10 years, as opposed to 15.
While these programs are helpful in certain situations.
I would avoid using them if possible.
This is because one of the biggest benefits of the RRSP.
Is that it allows your investments to grow tax free.
Borrowing money from the account reduces the amount
of time that your investments can grow tax-free.
With that said, if you need to buy a home ASAP
and the alternatives are not making an RSP contribution
and spending $25,000 on a home.
Or putting the money into the RRSP for 90 days
and then using the Home Buyers Plan.
I'd probably go with the RRSP contribution,
especially if you're in a high tax bracket.
Ideally though, you will max out your RRSP
leave the money in there and save up elsewhere for a house.
All right.
That was a general overview of how the RRSP works.
Now I'm going to tell you some of the most
common misconceptions that I hear
about this type of account.
Lots of people seem to think that there are penalties
or restrictions for withdrawing from an RRSP early.
That is not true.
There are no explicit age restrictions
or penalties for withdrawing
from the RRSP before retirement.
You can make a withdrawal any time.
When you make a withdrawal,
the financial institution is required to withhold tax.
The amount of withholding tax depends on the amount
of the withdrawal
But it has never more than 30%,
except in Quebec where it's 31%.
When you file your tax return in the year of the withdrawal
you'll either pay or receive the difference
between the withholding tax rate and your actual tax rate.
The withholding tax is not a penalty.
Remember that you deferred tax
when you used your RRSP deduction.
So you have to pay tax
When you make a withdrawal.
I said that there is no explicit penalty
for an early withdrawal, which is true.
But there is an implicit penalty.
When you make an RSP withdrawal, that room is gone.
This means that you used your contribution room
when you made a contribution, but unlike the TFSA
you will never get the room back after making a withdrawal.
The loss of RRSP room due to an early withdrawal is not good
for your long-term financial health.
The RRSP itself is not an investment.
I often hear people say that they want to buy more RRSPs.
Or that the RRSP is not a good investment.
That is not how this works.
The RRSP is just a type of account.
Inside of that account
you can hold cash, buy stocks, bonds GICs
or other qualified investments.
Unless you're using the RRSP to buy a house
or to fund your education in the near future.
Using the Home Buyers Plan or the Lifelong Learning Plan.
The RRSP is best used to hold long-term investments
like stock and bond ETFs.
Sometimes I hear that the RRSP converts dividends
and capital gains to income.
Making it a tax inefficient account, false.
It only looks this way
if you ignore the initial tax deduction.
There are two components of tax savings at work here.
The income tax deferral and the tax free investment growth.
Tax-free.
Let's think about how the RRSP works.
When you earn a dollar of income, it can go straight
into your RRSP without any taxes due to the deduction.
Alternatively, you could invest this money in the TFSA.
But you would have to pay some tax on it first.
Let's assume a 30% tax rate.
So you start with $1.00 in the RRSP
or $0.70 cents in the TFSA.
Fast forward, 20 years, assuming that
both the RRSP and the TFSA earned 5% per year,
the dollar in the RRSP is now worth $2.65.
While the $0.70 in the TSA is now worth $1.86.
But to spend the money in the RRSP, we need to pay tax.
If we assume the same 30% tax rate that we had
at the beginning, the RRSP ends
up being the exact same as the TFSA $1.86.
They both grew tax free.
When people think about the RRSP as being a bad deal
due to all of the taxes they have to pay.
They're ignoring the initial tax savings.
We just assumed the same 30% tax rate at the beginning
and end of our example.
If the tax rate were lower at the end,
the RRSP would have looked much better
than the TFSA after tax.
If the tax rate had been higher,
the TFSA would have looked better.
For most people, their taxable income
in their working and saving years, will be higher
than their taxable income in retirement.
This is a really important point for anyone trying to decide
whether they should use their RRSP or their TFSA.
If you were in a high tax bracket relative
to the tax bracket you expect to be in,
when you withdraw from your RRSP.
Then the RRSP has a good chance
of giving you a better after tax result than the TFSA.
Finally, tangent to what I was just talking about.
I find that people with pensions
will often avoid the RRSP altogether.
Remember, all you have to, to do is be in a lower tax rate
when you withdraw than when you contribute.
If you have a pension, you will typically not get more
than 70% of your working income as a pension benefit.
This means that you are likely to be in a lower tax bracket
in the future compared to when you were working.
Especially if you have a spouse
with a lower income to split your pension income with.
The one case where this might not hold true.
Is if your pension income after splitting,
is high enough to push you into OAS Clawback.
Which effectively increases your tax rate by 15%.
I mentioned briefly that you probably
want to be investing the cash that you put in near RRSP.
That is the second major benefit, tax free growth.
When you get to that point
there are some important things to keep in mind.
As always investing in low cost
total market index funds is probably the most
sensible approach for any long-term investor.
This is as true in the RRSP
as it is in any other account.
In terms of asset allocation
anything that goes into your RRSP needs to
be reduced by your expected future tax rate to
achieve your desired asset allocation.
I went into far more detail
in my video on this topic, but here's a quick example.
If you had $50,000 of bonds in an RRSP
and $50,000 of stocks in a TFSA.
Your pre-tax asset allocation is 50% stocks and 50% bonds.
But your after-tax asset allocation is what matters.
At a 30% tax rate your after tax asset allocation is closer
to 60% stocks and 40% bonds.
In the end it is only your
after-tax asset allocation that matters.
So this should be considered when you're deciding
on portfolio allocations.
This pre versus after tax asset allocation issue
only arises when you're holding different proportions
of asset classes in your various account types.
If you're using an asset allocation ETF
like VGRO or XGRO in your RRSP.
Then you do not have to worry about this
because every asset class is reduced proportionally
by taxes, keeping your pre and after
tax asset allocations the same.
If you are managing a portfolio of ETFs or stocks.
You may consider holding your U.S. listed equities inside
of your RRSP, as opposed to your TFSA.
This is because U.S. stocks
and ETFs are not required to withhold tax on dividends
paid to an RRSP account.
This means that both a U.S. stock
and the U.S. listed ETF of U.S. stocks can be held
in an RRSP account while avoiding the 15% withholding
tax that would otherwise be levied
if the asset were held in a TFSA.
Ideally you'll avoid holding a Canadian listed ETF
that owns a U.S. listed ETF
of international or emerging market stocks in your RRSP.
If you do this, you will lose two levels of withholding tax.
One from the U.S. and one from the international countries.
The same is true for the TFSA.
Similar to what I described in my video on the TFSA.
I would avoid holding individual stocks in the RRSP.
Risking your valuable RRSP room
for a bet that is unlikely to pay off
does not seem sensible.
If you want to know how unlikely that bet is to pay off.
Check out my video on picking stocks.
This video was meant to be a primer on the RRSP
how it works,
mistakes to avoid,
and some tips when it comes to investing.
I hope it was helpful.
Did I miss any misconceptions
or tips that people should know about?
Tell me about them in the comments.
Thanks for watching.
My name is Ben Felix of PWL Capital
and this is Common Sense Investing.
I will be talking about a new common sense
investing topic every two weeks.
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If you enjoy my Common Sense Investing video series
don't forget to check out the Rational Reminder podcast
which is available on all of the podcast platforms.
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