That time of year again. I’m not talking about winter, March break or the approach of the NHL playoffs. (Go Leafs Go!) No, I’m talking about RRSP season, that glorious time of year when Canadians nationwide scramble to make contributions to their RRSPs before the annual deadline, which for this year will be March 1, 2018.
A little background is probably in order. Since 1957, the humble RRSP (Registered Retirement Saving Plan) has been the product of choice for most Canadians who are serious about saving for their retirement years. Here are four reasons why contributing to your RRSP should be a no-brainer for you.
You don’t buy an RRSP; you open one, like a bank account. Consider your RRSP a great big virtual vault where you stash away money or investments for a later date.
The beautiful thing? Both the contributions to and the growth inside your vault are tax-free until you take them out. When you contribute to your RRSP, that money is deducted from your annual income at tax time, meaning you pay less income tax that year.
Of course, our friends at the Canada Revenue Agency are only going to allow you to defer so much tax. To that end, there are limits on how much they will allow you to contribute to your RRSPs each year. You may not contribute more than 18% of the past year’s income, less pension adjustment, up to a maximum amount that is adjusted every year.
An easy way to find out how much you’re allowed to contribute this year is to look at the Notice of Assessment you received from the CRA after you filed your income tax return last year; it will show you your personal RRSP deduction limit, plus any unused contribution room you have left over from previous years. The maximum contribution amount for the 2017 tax year is $26,010.
It is important to note that RRSPs are not tax-free; they are tax-deferred. (Same goes for their poorly named brethren, the Tax Free Savings Account, but that’s another story.) That said, there are some huge advantages to being able to postpone income tax payment until later in life.
First, many people are in a lower tax bracket during retirement than when they made their RRSP contributions, meaning they will pay less tax overall. Second, an RRSP contribution can give people a tax break earlier in life, when they usually need it more.
When you’re in your thirties or forties, you may have student debt to pay or mortgage payments to make, to say nothing of the cost of raising a family. During retirement, however, the house is (hopefully) paid for, the kids are out of that paid-for house, and your car insurance is dirt cheap. Paying taxes, while never fun, is a little more palatable under the latter circumstances.
Another reason your RRSP should be a no-brainer is the ease with which you can set them up for automatic, pay-yourself-first type contributions. In fact, the whole idea of an RRSP season is foreign to people who use this time-tested strategy.
They contribute to their RRSPs all year round, taking advantage of dollar-cost-averaging, and they never have to worry about finding a way to scrape together their contribution at tax year’s end.
Automated contributions also they eliminate the need or the temptation to borrow to make your RRSP contribution.
Broadly speaking (there are exceptions), I’m not a big fan of RRSP loans. You will have to pay back the money you borrowed, and if you can afford the loan payments, you probably could have afforded to make the weekly or biweekly contributions in the first place. The loan will end up costing you more than the contributions would have, because of the interest you are going to pay on the loan. Make interest — don’t pay it! Plus, the loan payments may hinder your ability to make automated contributions for the next year.
Simply avoid the need to catch up or to borrow by paying yourself (and your RRSP) first.
One of the most oft-stated, but nevertheless still remarkable, reasons for starting an RRSP, setting up automated contributions, and leaving it alone, is how much money you can generate through the amazing power of compound interest.
It’s money compounding on money, year after year after year. This is hardly a new concept, but the numbers still astound me.
Joe contributes $70 a week to his RRSP for 30 years at an average annual rate of return of 6.6%. Thirty years later, Joe has packed away $329,177 in his RRSP “vault,” even though he only contributed $109,200 of that amount.
Joe’s sister, Jane, socks away $90 a week for 32 years and earns a 6.9% rate of return. When Jane retires, she discovers that she has accumulated $520, 764 in retirement savings. Jane’s contributions? $149,769. Only 29% of Jane’s retirement savings actually came from Jane’s actual savings. Compound interest generated the rest.
Then there’s Jake, Joe and Jane’s cousin. He starts early, goes large, and manages to save $157 a week for 39 years. Through a combination of low fees, discipline, and a little luck, Jake’s RRSP portfolio generates an average annual rate of return of 7.8%. When Jake hangs up his skates (metaphorically speaking), he’ll be sitting on a cool $1,912,913. He will have contributed only $318, 396 (17%) of that amount. Astounding.
There is a dizzying array of investment options available to you inside your RRSP: stocks, bonds, ETFs, GICs, treasury bills, term deposits, mutual funds, index funds, and so on and so on and so on.
There are choices for everyone, from the most conservative to the most speculative investor. Since I’m a big fan of keeping my investment costs as low as possible, I employ a “buy and hold” mix of very low-cost, globally diversified ETFs in my RRSP, but I also recognize that strategy may be too passive for some investors.
Whatever fits your risk profile, you can invest in it inside your RRSP.
Seventy-one years after its inception, the RRSP remains the go-to financial product for most Canadians who want to spend their retirement years teeing off with their drivers, as opposed to scraping ice off their windshields in January.
RRSPs offer tax advantages through deferment, ease of execution through automated contributions, and the potential for amazing results through the power of long-term compound interest growth, coupled with flexible investment options.
No-brainer.
Fore!
Robert R. Brown is the author of the Canadian bestseller Wealthing Like Rabbits – An Original and Occasionally Hilarious Introduction to the World of Personal Finance.
Follow Rob on Twitter @wealthingrabbit