Nancy Graham May 13, 2019 Living in Retirement Personal Wealth The Elephant in the RRSP Planning Room What’s that? You’d love to retire in style someday? Fortunately, most working Canadians can use the Registered Retirement Savings Plan – or RRSP – to pile up tax-deferred dollars for whatever their retirement-planning hearts may desire. But, from what I hear, there’s confusion about what the RRSP can – and cannot – do for you. While it would take quite a conversation to cover every angle, let’s focus on one elephant in the room. Specifically, I often see investors overlooking the jumbo-sized potential for enormous investment growth in their RRSP, while fussing over its many other, relatively flea-sized factors. Making Room for Retirement Are you already maxing out the room in your RRSP? If so, good for you! If not, that may be fine too. As I’ve covered before, business owners might have good reasons for stashing at least some of their retirement dollars elsewhere. But, sometimes, when I see people underplaying their RRSP contributions, it’s because they’re confused about how the program works to begin with. Basically, any year you earn income, you can take up to 18% of it and stash it in your RRSP account in the following year. This is called your RRSP “room,” or space available, for contributing tax-deferred dollars. As usual, there are some caveats to cover as well: Your 18% room eventually bumps into an annual maximum “wall.” For example, in 2019, the maximum room was $26,500, calculated based on your 2018 earned income. If you’re good with a calculator, that means you really only get to make contributions based on up to about $147,000 in annual earnings. That’s not all. If you pay into a pension plan or deferred profit-sharing plan, these contributions also count toward your available 18% room. And if you accidentally contribute too much, there can be penalties. So, do check your CRA Notice of Assessment to ensure you haven’t overdone it. Thankfully there is a $2,000 buffer you can overcontribute without incurring a penalty. Managing for Tax Efficiency Why bother with all these rules to begin with? First, there are potential tax benefits. For every dollar you put into your RRSP, you get to deduct a dollar from your income tax return. (Except for that $2,000 excess contribution buffer amount I mentioned. You won’t be penalized on it, but it’s not deductible). Now, if a tax deduction were the only benefit, it might not be that big a deal. If you were reading closely, you may have noticed I called the RRSP tax-deferred – not tax-free. When you withdraw the assets, you end up paying income taxes then. Plus, you pay ordinary income tax on everything you withdraw from your RRSP, including any investment gains you’ve earned over the years Does that mean the RRSP is just a big shell game? Not for most taxpayers. There are several broad tax-saving “levers” you get to control, to make your RRSP work hardest for you. Taking Your Time: When you make your deductible contributions, you don’t have to take those deductions right away. You can tuck them up your sleeve until you need them the most. Say there’s a year you receive a significant tax payment, like a bonus. You can pull out those deductions you’ve stashed away and lay them on the table, to offset the extra income. That’s a nice little tax-planning play many investors aren’t aware of. Tax Rates in Retirement: As long as you are in a lower tax bracket when you withdraw your RRSP assets you may still receive an overall tax break by deferring the taxes until then. That’s often the case in retirement. Calculating Capital Gains: What about that treatment of capital gains as ordinary income? Without getting too deep into it, know that the government has planned for that part of the equation. Once you crunch all the numbers, most tax payers come out at least even, if not ahead on total taxes due. Back to That Elephant: Tax-Sheltered Investment Growth Now to my biggest point. It’s true, there are all sorts of ways you and your tax planner can fiddle with your RRSP and other tax-sheltered accounts to make your best, most tax-friendly plays. But I would propose these benefits can be flea-sized compared to an even greater possibility. Among the biggest advantages of holding investments in an RRSP account is they incur no annual taxes along the way. No taxes on capital gains. No taxes on dividends. No annual taxes, period. You only pay taxes on withdrawal. It may not be immediately obvious, but thanks to the power of compounding returns, this can give tax-sheltered investments a huge advantage over the same holdings in a taxable account. Compounding lets your earnings begat more earnings, which in turn snowball into even more earnings. For example, assume you socked away 67 cents of after-tax dollars in your RRSP when you were 20 years old. You let it ride for 50 years inside a balanced portfolio of 60% stocks and 40% bonds. In an RRSP, your 67 cents would grow to around $7.04. Had you invested it in the same way in a taxable account, it would only grow to around $5.00. Two dollars may not seem like much, but what if your youthful investment were more like $1,000, with more added along the way. That could add up, fast. In short, compound returns are a significant reason for putting money into your RRSP. It’s also a huge reason for leaving it there as long as possible, hopefully until the government requires you to start taking it out. By taking advantage of this tax-deferred benefit, you can expect to end up with a much bigger pile of money to call your own in retirement. If you end up paying a few more taxes because you’ve got a lot more money, isn’t that a good “problem” to have? What else is on your mind with respect to your retirement? Let me know, and I’ll keep pumping out more good power plays for you to consider. 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