At this time of year, Canada is awash with talk of saving for retirement, be it water-cooler gossip, media stories, tweets or other chatter afloat in the computing cloud. The theme is invariably skewed toward reasons why you must contribute to your RRSP. However, putting money toward what is essentially an income-tax-deferral strategy does not make financial sense for everyone. Here are five personal circumstances where your hard-earned dollars might be better deployed elsewhere this year.
1. You've got debt
If you are carrying any high-interest debt such as an outstanding credit-card balance, your first priority is to pay off this debt. Here's why. The typical major bank-sponsored no-annual-fee credit card charges about 19.5% interest. It is highly unlikely that your RRSP will deliver the return needed to match the return achieved by paying off the outstanding balance on such cards.
In his book Enough Bull: How to Retire Well Without the Stock Market, Mutual Funds, or Even an Investment Advisor (Wiley, 2009), author David Trahair goes further and advocates "paying off all debt, including your house mortgage, before investing another dime in your RRSP." What makes his so-called "tax-turbo-charged RRSP" worth investigating is that unused RRSP contribution room carries forward to future tax years. Once you are debt-free and have more cash available, you can take advantage of your built-up contribution room. At that point, you'll probably be in your peak earning years and highest tax bracket, so you will receive the highest tax refund per dollar contributed.
2. You haven't made your 2011 Tax-Free Savings Account (TFSA) contribution
Making your $5,000 annual TFSA contribution should be your first priority for any available cash if you expect that your top marginal income tax rate will be similar or higher in the future. TFSAs are more flexible than RRSPs. You can withdraw money from your TFSA and re-contribute the full amount withdrawn in the following year or later without paying any tax. In contrast, money pulled out of an RRSP will be fully taxed and the contribution room is lost forever.
3. You need to save for a child's education
If you contribute $2,500 to a Registered Education Savings Plan (RESP) for an eligible child, 17 or younger, the federal government provides a $500 Canada Education Savings Grant. That's an immediate 20% return on your money and you'll still have your RRSP contribution room to use in future years.
4. Your RRSP is big enough
Once you reach age 71, you must close out your RRSP. For most people, this means rolling RRSP funds into a registered retirement income fund (RRIF). Money must be withdrawn from the RRIF at the government-mandated withdrawal rate or higher. The Canada Revenue Agency deems every cent of this withdrawal to be taxable income.
Furthermore, the required RRIF withdrawal could push your net income before adjustments (line 234 on the tax return) over the federal government's Old Age Security (OAS) clawback threshold ($67,668 for 2011, adjusted annually for inflation). If so, you will be subject to the Old Age Security Recovery Tax, which claws back your OAS at 15% per dollar of net income over the threshold.
So, how big is big enough for an RRSP? It all depends on your other sources of retirement income. Here are a couple of simplified scenarios to give you an idea of the size of an RRSP which, once converted to a RRIF, will generate income at the OAS clawback threshold. For both examples, the maximum Canada Pension Plan (CPP) and OAS benefits are assumed.
First, let's say a retired person has an annual pension income of $35,000. Adding the OAS ($6,291) and CPP ($11,520) amounts would bring her income to $52,811, leaving a net income room of $14,857 before she reaches the clawback threshold. Assuming she withdraws 7.38% from her RRIF assets (which is the required minimum amount in the calendar year that she turns 71) she would need $201,314 in RRIF assets to produce an income of $14,857.
In the second scenario, a retiree with no pension income would need RRIF assets of $675,569 for that 7.38% withdrawal to bring his net income up to the clawback threshold.
|CPP (maximum )||11,520||11,520|
|Net-income room left to reach clawback threshold||14,857||49,857|
|Value of RRSP/RRIF yielding the above income room||201,314||675,569|
If you have a workplace pension plan or other sources of taxable income, directing some or all of your retirement savings to non-RRSP investments will offer more tax-planning options. For example, you could buy and hold stocks that will hopefully increase in value. As long as the stocks are not sold, your unrealized profits will not be taxed.
5. You expect to receive income-tested government benefits after retirement
At age 65, Canadians start receiving OAS from the federal government. If you are a low-income senior living in Canada, you can also apply for the Guaranteed Income Supplement (GIS) benefit. To qualify, your previous year's annual income (before income-tested benefits) must not exceed defined limits. Currently, the limit is $15,888 for a single person and $20,976 in combined income for a couple.
An RRSP, once converted into a RRIF or annuity, will generate income that will reduce or eliminate the GIS. Given this, low-income Canadians should probably direct any available cash for retirement savings into a TFSA. Withdrawals from a TFSA will not trigger clawbacks of income-tested government benefits and tax credits.