By Gordon Powers, January 15, 2011
When not to invest in RRSPs
Despite the attractive tax savings available, RRSPs are probably not the best choice for many Canadians.
If you believe the hype, every adult Canadian should be maximizing their RRSPs through some kind of monthly pre-authorized chequing plan.
But it's worth noting that some people will probably be better off not investing in an RRSP at all. And, for many others, they're still likely a low priority.
If you're in a higher tax bracket, then making the maximum RRSP contribution as early as possible should pay off. But for more modest earners straining under the weight of high-cost consumer debt, or lower-income seniors approaching retirement, the case is not as clear.
And the addition of the Tax Free Savings Account a couple of years ago has muddied the waters even further.
Ideally, you're looking to invest in an RRSP when you're facing a high marginal rate and then take it out when you're subject to a lower tariff. If it looks like it's going to be the other way around, you're not going to be better off in the long run.
That's why, in some instances, there may be an advantage to intentionally storing up RRSP room, and using a TFSA in the interim. Should your income jump, TFSA funds can be withdrawn to make an RRSP contribution, creating TFSA repayment room at the same time.
This might appeal to young doctors, for example, since their income generally jumps significantly after completing years of training. This might also be true for entrepreneurs who hope to hit the big time at some point.
Reducing taxes isn't the only reason to have an RRSP, of course. The savings habit quickly becomes ingrained, the deduction can be carried forward indefinitely to be used in higher-income years and the money you earn is tax-deferred.
Despite this, many investors in the lower tax brackets — roughly $37,000 or below in Ontario — may have much less to gain from making an RRSP contribution than they think, particularly as they get older.
Potential buyers who are less well off and expect to receive the federal Guaranteed Income Supplement — currently available to Canadians earning less than $15,816 a year and couples with joint incomes under $20,880 — should probably think twice about RRSPs, for instance.
And that's a fairly large group since roughly one third of seniors can expect to receive some sort of government income supplement, according to the most recent Stats Can data.
For these low-income retirees a bit of extra income from RRSPs can actually erode their standard of living. That's because it counts against their GIS, which is reduced by 50 cents for every dollar of retirement income.
And they'll likely also lose out on other benefits like rent subsidies, drug benefits, home care and social aid programs as well.
This group should not only forego putting any money in RRSPs, but should also consider cashing out so there's nothing left in their plan by age 65. The tax paid each year will otherwise offset the additional benefits.
There are other circumstances where an RRSP is probably not your number one priority.
Considering debt levels in this country, there are quite a few people who fall into the category of paying off their debt before building up a retirement plan.
If you've got a stack of high-interest credit card or auto debt, you're going to be much better off paying it down and deferring potential RRSP contributions until you work those loans off.
Even consumer loans at lower rates of interest, given that rates have been so low for quite awhile now, can be troublesome.
Although the decision isn't as clear cut, anyone with mortgages or student loans will need to consider whether or not paying off these debts, or at least making larger payments, is the more prudent option.
Although loans like these usually come with a relatively low interest cost compared to credit cards, there's still no guarantee that you'll make a high enough return to offset the interest costs.
Generally speaking, especially if you're a conservative investor, paying down your mortgage should probably take priority here, particularly if you expect to earn a guaranteed return by investing in GICs with the RRSP.
For some, doing a bit of both might make some sense. You can do this by making your RRSP contribution first and then using the tax savings to pay down the mortgage.
Of course, it's not only the heavily indebted that need to rethink their approach. For example, many small business owners actually register fairly modest incomes year over year, preferring instead to boost the value of their businesses.
The conventional wisdom has generally been that you should take a salary from the business to maximize RRSP contributions, and then consider a different combination of business income after that.
But, according to a new report by Jamie Golombek, CIBC's managing director of tax and estate planning, most business owners should think twice about this RRSP strategy and instead consider sticking with dividends, leaving any excess cash in the company.
The bottom line: RRSPs are not always the no-brainer they're advertised to be. Be sure to talk to someone in the know before you jump in.