Canadians are using their self-directed Registered Retirement Savings Plans (RRSPs) to build portfolios of investments that can provide retirement income along with company and government pensions. The market correction in dividend stocks and the surge in rates on Guaranteed Investment Certificates (GICs) over the past year is giving RRSP investors a great opportunity to put cash to work.
RRSP basics
The Canadian government created the RRSP in 1957 as a tool to help people put money aside for retirement. The contribution room and flexibility of the product have evolved over the years.
Canadians can contribute up to 18% of their earned income reported for the previous tax year. The government puts a cap on RRSP contributions. The maximum RRSP contribution is $30,780 in 2023. It will be $31,560 in 2024, putting earned income above $175,000 as the threshold for the maximum.
Unused RRSP contribution room can be carried forward. This is important for people to consider if they expect to have higher incomes in the coming years. RRSP contributions reduce taxable income for the relevant year, so the best bang for your RRSP contribution buck occurs at higher marginal tax rates.
RRSP investments can grow tax-free while held in the plan. Investors pay taxes on the funds when the money is removed. RRSP withdrawals are treated as income. Ideally, contributions to the RRSP are made at a higher marginal tax bracket than when the money is eventually pulled out in retirement.
Investors have to watch out for a few RRSP rules that can cause them grief. Contributions to a company pension plan are counted against the RRSP contribution room, so people with generous employer pension benefits might not have much RRSP contribution room left after the corporate contributions are counted. The government allows people to contribute over their RRSP limit by up to $2,000, but then implements a penalty tax of 1% per month on amounts above $2,000.
Best RRSP investments
People can hold a wide range of investments inside their RRSP. Mutual funds, stocks, bonds, exchange-traded funds (ETFs), Guaranteed Investment Certificates (GICs), savings deposits, and treasury bills are the most common. Alternative investments, including some mortgages, are also permitted.
Now that five-year GIC rates are in the 5.5% range, GIC investments deserve to be on your RRSP radar. GIC interest on multi-year certificates can be directed to reinvest at the term rate. Another popular strategy for building RRSP wealth involves owning top dividend stocks and using the distributions to buy new shares to also take advantage of the power of compounding.
Fortis
Fortis (TSX: FTS) is a good example of a top TSX dividend stock that has helped make some long-term investors quite rich.
The board has increased the dividend annually for the past 49 years. This type of reliable distribution growth typically leads to an upward drift in the share price. The combination of the dividend increases, reinvested distributions, and a higher share price boosts total returns and can turn a modest initial investment into a meaningful pile of savings over the course of 20 or 30 years.
The bottom line on building RRSP wealth
Owning dividend stocks comes with risks. Sometimes good companies get into trouble and don’t bounce back. Top dividend-growth stocks, however, normally recover from pullbacks and eventually hit new highs.
In the current environment, it makes sense for RRSP investors to build a diversified portfolio of GICs and top dividend stocks. This strategy requires the discipline to ride out the dips and the courage to buy when markets correct, but using dividends to harness the power of compounding can deliver attractive long-term results.
