Understanding your RRSP contributions
With just days left before the RRSP deadline on March 1, many Canadians are struggling to put together a contribution to lower their 2020 tax bills. According to BMO’s annual RRSP survey, the pandemic has many registered retirement savings plan holders sitting out this year, but it finds the average amount held in RRSPs is up 41 per cent since 2015 to $112,295.
Yet, as our retirement nest-eggs grow, our understanding of RRSPs is lagging. Here are five common blunders and oversights that could be draining your savings.
1. Contributions can ultimately be costly
That’s right. Even if your annual contributions remain below the allowable limit, your RRSP savings could grow to a point where it could be costly to access them. Those contributions and the returns they generate as investments over the years are fully taxed when they are withdrawn. The marginal tax rate is based on your income the year of the withdrawal. The bigger your income, the bigger your tax rate.
Even holding off on withdrawal amounts won’t help. When an RRSP holder turns 71, the plan must be converted to a registered retirement income fund. A RRIF is like a reverse RRSP; money goes out instead of going in.
Once the plan is converted to a RRIF, the Canada Revenue Agency requires minimum withdrawals based on the total amount in the plan, which could result in withdrawals in a higher tax bracket. If the amount reaches a certain threshold, Old Age Security (OAS) benefits could be lowered or clawed back.
2. Early withdrawals can also be costly
Since withdrawals are taxed according to your marginal tax rate it might make sense to take money out of your RRSP in years where your income is seriously reduced; perhaps due to the pandemic. You can also avoid any tax if the funds are used to purchase a first home or go back to school (provided the funds are returned within a certain period of time).
However, withdrawals before age 65 are subject to a withholding tax as high as thirty per cent. If your income is low, you will get some of that cash back when you file the next year. If your income is the same as most years, or more, the extra withdrawal amount will likely push you to a higher rate than your initial tax savings in the year you made your contribution.
If you make an early withdrawal you also lose the allowable contribution space if you are looking for a tax shelter in future, higher income, years.
3. Treating your RRSP like a day-trading account
The BMO survey found only half of Canadians are aware of what investments can be held in RRSPs; a ten per cent decrease from 2015.
Just about anything can be held in an RRSP: stocks, bonds, mutual funds, exchange-traded funds (ETFs), derivatives, and even cash.
Having such a wide choice over a long period of time allows for steady growth and low risk through diversification.
Hanging your retirement on a few flavour-of-the-day, high-risk investments could end in heartbreak. Save those for your tax-free savings account (TFSA).
4. Ignoring fees
Diversifying a portfolio over a long period of time often involves professional management, and good management costs money.
Fees are often based on a percentage of the total amount invested. Annual fees on mutual and exchange-traded funds could top four per cent. That could add up to a significant reduction from your investment returns and actually become a drag on portfolio growth.
Ask about fees from the start. If you feel the cost of professional management is too high, consider low-cost investment alternatives such as fee-for-service advisors, robo-advisors or ETFs.
5. Borrowing to invest or neglecting high-interest debt
Some financial institutions have figured out ways to get you to pay for investment services while paying them interest by providing RRSP loans. It’s important to know that any interest rate you pay on debt is a certain loss against uncertain investment gains.
Those same financial institutions pushing their RRSP products often fail to mention that paying down high-interest debt should come first. Balances owing on credit cards could be as high as thirty per cent.
The tax and investment advantages from contributing to an RRSP before paying down debt can be more compelling for lower interest rate debt such as mortgages. In many cases it’s good to do a little of both.