RRSPs: 10 things you need to know

by Paul Russel - January 2013, moneyville.com

Pity the poor Registered Retirement Savings Plan (RRSP). With middle age setting in after more than 50 years - and the new tax-free savings account getting all of the attention - the lowly RRSP can seem like yesterday's news.

In fact, nothing could be further from the truth. RRSPs continue to represent one of the most significant tax savings opportunities available to individual Canadians - and one of the most effective ways of saving for retirement.

Here are 10 things about RRSPs that highlight the central role they can play in your financial planning for retirement, along with some tips on how you can maximize the benefits they provide.

#1. Your biggest tax break

The taxes you save with RRSP contributions are significant because every contribution you make is tax deductible. If you're in the top tax bracket, every $1,000 you contribute gives you over $400 back as a tax break.

#2. RRSPs grow tax free

That $1,000 also grows tax-free inside your RRSP account. This tax-sheltering accelerates the growth of over the years and provides a huge boost to your retirement nest egg. While all withdrawals are taxable, you will have enjoyed many years of tax-sheltered growth in the meantime, and - if you keep your RRSP intact until retirement - you may also benefit by being in a lower tax bracket when you start making these withdrawals.

#3. Time your contributions

The tax deduction for your RRSP contribution can be carried forward indefinitely, so you can make use of it in a future year when it would be more advantageous. For example, if you have an income of $60,000 this year, but expect that salary increases and promotions might bump your income to $90,000 in a few years time, holding off on claiming your deduction could increase your tax savings by as much as 50 per cent due to the fact that you'll be taxed in a higher tax bracket.

#4. RRSPs matter - even if you have a pension

Other than top-end public sector pensions, few plans are designed to provide all of the retirement income you'll need, so saving on your own through an RRSP can be essential. For example, let's assume your workplace pension plan provides 40 per cent of your needed retirement income of $45,000, with government programs such as the Canada/Quebec Pension Plan and Old Age Security providing 30 per cent. That still leaves you to come up with the remaining 30 per cent. That's where saving through your RRSP can be so important.

#5. Contribution limits increase

Your RRSP contribution limit is scheduled to increase each year, so if you're able to make the maximum contribution, you'll want to keep track of contribution limit changes.

For the 2012 tax year, you can contribute 18 per cent of your 2011 earned income, to a maximum of $22,970, less any pension adjustment (the benefit you received from an employer's pension plan or deferred profit sharing plan in the previous year). The contribution limit will increase to $23,820 in 2013, and then be indexed to inflation based on increases in the average industrial wage for years following.

#6. Unused room can be carried forward

If you don't use up your contribution limit in any one year, your unused contribution room is carried forward indefinitely. So you can always catch up on your contributions if you don't save the maximum amount in any given year. That said, the sooner you get your money in your RRSP, the more time your investments will have to compound, or earn interest on the interest. That extra time can mean a big boost to your retirement savings.

# 7. Don't dip in along the way

It's so tempting to withdraw money from your RRSP to handle some of life's little needs or challenges, or to take advantage of the Home Buyers' Plan for a home purchase or the Lifelong Learning Plan to pay for education expenses.

But those early withdrawals can be costly. For example, if you withdraw $10,000 from your $100,000 RRSP nest egg - and your remaining RRSP assets earn a 6 per cent return each year for the next 20 years - your RRSP will be worth more than $56,000 less than if you hadn't made the withdrawal.

In addition, when you withdraw funds from an RRSP (other than through the Home Buyers' Plan or Lifelong Learning Plan), you permanently lose the contribution room that you originally used to make your deposit. While you can continue making your maximum contribution to your RRSP in the future, you are not allowed to re-contribute the amount you withdrew.

#8. There's plenty of choice

If you went to your local bank branch several years ago to open your RRSP, chances are that your investment choices have been limited to their own "in house" mutual fund and GIC offerings. If you have a growing account balance ($25,000 or more), you should consider moving your savings to a self-directed RRSP. A self-directed RRSP is available from many financial institutions (such as full service and discount brokerages) and is no different than other RRSPs, only your investment choices are not restricted to in-house brands. This means you can choose from virtually any qualifying investment, from GICs to mutual funds from any issuer or fund company. More choice means more flexibility in making the investment choices that are right for you.

#9. Allocate investments tax effectively

If you are saving through both an RRSP and a non-registered account, consider structuring your portfolio to hold investments that are taxed at a higher rate, such as GICs, inside your RRSP and hold investments that are taxed at a lower rate - those that generate dividends and capital gains - inside your non-registered portfolio. This strategy allows you to maintain your desired asset mix of investments while minimizing the taxes you pay on your non-tax-sheltered investment income.

#10. Automatic deductions make it easy

Few people have the money at hand to make their maximum RRSP contribution at the contribution deadline. One of the most effective ways of saving more is to commit to making regular contributions in small amounts. Almost all financial institutions and brokerage firms will set this up for you automatically. You'll be amazed at how little you'll notice a small deduction from each paycheque, and you'll have a sizeable amount contributed by year end.

Using Your Nest Egg Early May Cost You

by Boomer - January 2013, boomerandecho.com

A Statistics Canada study indicates that more Canadians are cashing in their RRSP savings long before they reach retirement.

The money tucked away in your Retirement Savings Plan can be a tempting source of cash.  But think twice before withdrawing money from your retirement nest egg.  The amount you withdraw is considered income for that year and taxed accordingly.

Unless the withdrawal is made under the Home Buyers' Plan or the Lifelong Learning Plan, you'll immediately be hit with a hefty withholding tax, which may not cover all the tax payable.  Over the long term the cost of dipping into your RRSP early is even higher.

Early withdrawals from your RRSP have hidden costs that can do long term damage to your retirement plan.  Consider this example:

Jason has diligently contributed to his RRSP every month and now has a sizable investment of $100,000.  He wants to buy a new car and needs $25,000.

He can take out a loan, but he doesn't want to pay the loan interest.  On the other hand he can use some of his retirement savings.  After all, he thinks he still has lots of time to save before he'll need the money for retirement.  What's the best option?

If Jason takes out a $25,000 loan at an annual rate of 7.5 % over 5 years, he'll pay about $5,060 in interest costs.

If he taps into his RRSP to buy the car, he'll actually have to withdraw $35,715 ($25,000 plus $10,715 to cover the mandatory 30% withholding tax).  This leaves his RRSP with $64,285.

Assuming the remaining balance grows at an annual compound rate of 4% over the next five years, his RRSP will increase in value to $78,212.

If he had left his plan intact, he would have $121,665.

In other words, the loan would cost about $5,000 in interest over five years while the RRSP withdrawal would cost him more than $43,000.

This doesn't take into account any additional income tax that may apply when filing his tax return and, unlike with a TFSA, there is no opportunity to replace the borrowed money, as the contribution room will be lost.

Over 20 years, the cost of the lost compounding rises to $95,208.

An RRSP withdrawal made through the government's Home Buyers' and Lifelong Learning programs is not subject to withholding or income tax.  However, you have to repay the money in equal installments over the next 15 years.

If you miss a repayment, the amount will be added to that year's income and taxed at your marginal tax rate.

Many will argue that higher education is an investment in greater future earnings and a house is an asset that will appreciate over time.

Also, borrowing from savings to purchase a house will allow you to make a more substantial down payment which enables you to avoid or reduce CMHC mortgage insurance fees and build the equity in your home faster.

However, the combination of a large withdrawal and a slow repayment schedule can have a significant impact on the growth of your retirement savings so think it through carefully.

While you don't lose the contribution room, you will lose several years of tax-sheltered compound growth while you repay the loan.  The faster you're able to pay the money back, the less growth you will lose.

Dipping into your RRSP for quick cash may seem tempting, but is it a wise move financially?

Over the long run it will likely prove to be very costly and will damage your retirement plan.  The withdrawal of even a small amount can have a substantial impact on the value of your savings and you will have to adjust your plan to ensure that you'll still have sufficient funds to afford the lifestyle you want.

But what if you need funds?  If a financial emergency arises and you need cash, look at other alternatives first before making an RRSP withdrawal.

Consider your non-registered assets or TFSA.  A line of credit will offer a lower interest rate than a fixed term loan.

In most cases, though, it's better to use the many different, more suitable, savings options available to you for both emergencies and future purchases.