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Are RRSPs Really Beneficial?

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As we enter February, the RRSP (Registered Retirement Savings Plan) season begins to heat up.  Various financial institutions and mutual fund companies kick their marketing campaigns into high gear prior to the the March 1st RRSP deadline, in what is generally the most successful month of the year (in terms of new money flowing in).  However, most campaigns ignore our individual goals & tax situation, and entice us to blindly purchase RRSP investments.  They paint the perfect picture of retirement, funded by matured RRSP investments, where taxes on them are supposedly lower.  But are RRSPs worth it?  Are RRSPs a good investment?  Is contributing to RRSPs truly beneficial or useful?  Will taxes on matured RRSP investments really be lower?  Not necessarily, and in many cases it won’t be.

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Registered Retirement Savings Plan (RRSP) :

A Registered Retirement Savings Plan (RRSP) is a type of Canadian account registered with the Canada Revenue Agency / CRA (usually by a financial institution) for holding savings & investment assets in order to promote saving for retirement.  Contributions are subject to certain restrictions and limitations set out in the Canadian Income Tax Act. A tax credit is also given for contributions made to a RRSP.     Income and capital gains are not taxed while within the plan, and is deferred until withdrawn.

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Benefit Of RRSP Dependent On Your Marginal Effective Tax Rate :

Because RRSPs are tax deferred, they allow investments to grow (or shrink) without being taxed while inside the plan.  The idea is that we will have much less income in retirement (when we withdraw), than we have today when we make the contributions.  Then when we withdraw from the plan, the proceeds will be taxed at a lower tax rate. Many people will generally end up being surprised that it will not likely be the case, and they will end up being taxed like they never imagined. This is because the benefit of the RRSP program is highly dependent on your marginal effective tax rate at the time of contribution, and at the time of withdrawal.

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Marginal Effective Tax Rate (METR) :

Your marginal tax rate (MTR) is the amount of tax applied to an additional dollar of income that is above a certain federal income tax bracket level.  Your average tax rate (ATR) is the average amount of tax calculated by dividing the total amount of tax paid by your by total income.  Your average tax rate will usually be significantly lower than your marginal tax rate.  Your marginal effective tax rate (METR) or effective marginal tax rate (EMTR) is a bit more complicated.  It is the amount of tax applied to an additional dollar of income (or next dollar earned) taking into account the combined effect of taxes and benefits (federal & provincial income tax brackets & rates, tax credits, deductions, federal & provincial benefits that are subjected to income-tested thresholds).  For most workers, the METR changes drastically (negative to positive, low to high) at many different levels of income.  This is mainly due to both federal & provincial clawbacks of certain benefits and the elimination of tax credits that are tested against income, which results in changes to the tax rate paid on the next threshold of income.

Unfortunately determining what your METR will be during retirement Is not a quick and simple number to determine today.  It depends on so many individual factors, many of which are in the future and will be unknown, including the future rates and threshold levels.  However, you can think of the factors now in order to help you get an idea of what it may be in the future relative to what it is today. This relative difference, is what you need in order to determine whether RRSPs will benefit or hinder you in the future.  Most people assume that the their METR will be higher while they are working. and lower then they are retired.  During retirement, your METR will also be calculated based on a combination of savings, retirement income from pensions (private, government, etc), and other benefits which you likely don’t have now.  These will all fall under various income thresholds.  It is likely for low and middle income earners that their METR will NOT be lower at retirement, but will be actually higher.  Contributing to RRSPs will likely generate very little to no tax savings, and may actually trigger larger taxes & penalties. For high income earners, it is likely that their METR will be lower at retirement than it is today.  Contributing to RRSPs would generate large tax savings for those earners.

To help you get a better understanding of your current METR you can use the following tax calculator at TaxTips.ca, which calculates the effect of tax credits, benefit clawbacks, RRSP contributions, etc:
http://www.taxtips.ca/calculator/cdncalculator.htm

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Also read the following publications that help to illustrate how the different factors affect METRs :
• C.D. Howe Institute – METR on Low Income Families (Canadian Marginal Effective Tax Rates) 2008.
• Congress of the US Congressional Budget Office (CBO) – Effective Marginal Tax Rates on Labor Income (US Marginal Effective Tax Rates) 2005.
- The United States also has a progressive tax system, resulting in many similarities.  Statutory federal & state income tax brackets thresholds & rates, as well as deductions, tax credits, and income-tested benefits, affect the METR to a similar degree.

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Lack Of Information :

Adding to the problem is the lack of detailed information.  The financial institutions, and even the Canada Revenue Agency (CRA) themselves, mention very few details regarding the withdrawal of RRSP investments.  All they mention is that that you should consider the tax ramifications before we hit 65-71.  However, they do warn of the withholding tax (but fail to clearly explain it) ,and other restrictions, but usually in association with withdrawals before you hit “old age” (no age is ever defined).  They do not give any information that is useful in planning your long term retirement.  In contrast, they only provide detailed information regarding how to set up, transfer, and make contributions.

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RRSP Contribution Tax Credit :

Financial institutions try everything in order to get individuals to make contributions, and in the process purchase their funds and other investment products.  A tax credit is given for making contributions to a RRSP, and financial institutions use this to their advantage.  People are enticed and blinded by the thought of getting some money back when they contribute, without realizing that they may end up paying more in taxes, or and losing government benefits (clawbacks) upon retirement.  The tax credit feeds into human impulsiveness & instant gratification.  The idea of receiving something back right away, combined with the easy solution to retirement (often marketed as “the most effective retirement saving and investing tool available to most Canadians”, BMO), entices people to forget about their individual tax situation and long term planning.  However, deeper thinking of more complicated issues, and delayed gratification in long term planning, should be encouraged in order to be able to make a more informed decision.

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The RRSP to RRIF Limitation :

RRSP withdrawals do not qualify for a tax credit, but Registered Retirement Income Fund (RRIF) payments made to people 65 and older are eligible. By law, your RRSPs must be wtihdrawn as a lump sum or converted to a form of retirement income by the end of the calendar year in which you turn 71.  You would need to convert some of your RRSP savings to a RRIF in order to take advantage of the tax credit. But you dont have to convert the entire amount, just enough to enable you to withdraw $2,000 a year. You are allowed to have both a RRIF and a RRSP until age 71.  Once the RRIF is set up, minimum withdrawals must be made every year. But if you keep the RRIF small, it should not create a tax problem.  However, when you look at the RRSP and RRIF together, we can see that they do present tax problems.  It will be difficult to keep your RRIF small if you must convert all your RRSPs (the majority of your retirement savings according to financial institutions & CRA) by 71, as RRIF withdrawals will likely exceed $2,000 year.  If you do not convert RRSPs to a RRIF, you need to withdraw it all as lump sum and pay hefty taxes!

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RRSP Withholding Taxes :

When financial institutions trumpet that your “RRSPs allow your investments to grow tax free” it is true and sounds great (also helps boost sales).  What they forget to do is remind people that even though investments grow tax free, they are taxed when you withdraw them!  All funds withdrawn from a RRSP are considered taxable income, and will be charged withholding taxes upon withdrawal. This is the case regardless of age or income, and is dependent on residency and the amount withdrawn.  This amount must be held back by the plan administrator and remitted to the government on your behalf.

For example, if you were retired and had no other income in the year of withdrawal from your RRSP, the financial institution would still hold back the withholding tax and remit it to the government. The amount of tax withheld would be considered paid.  You can think of the withholding taxes as being similar to how taxes are withheld on each paycheque when you receive it.  Unfortunately, the withholding tax may not be the only penalty/tax you would incur, as certain benefits at old age may be clawed back.   In addition, you may or may not get the amount back once you file your tax return, as it depends on your total income for the year and your marginal tax rates. You may even owe more in taxes.

All provinces except Quebec / Quebec :

Up to and including $5,000 = 10% / 5%
$5,000.01 to $15,000 = 20% / 10%
More than $15,000 = 30% / 15%

“When you withdraw funds from an RRSP, your financial institution withholds the tax. The rates depend on your residency and the amount you withdraw.“  “The tax that was withheld may not always be enough to account for the tax you owe at your tax bracket. You may have to pay more tax on the withdrawal when you include the withdrawal on your tax return for that year.” –  Canada Revenue Agency [Tax Rates On Withdrawals]

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Old Age Security (OAS) & Guaranteed Income Supplement (GIS) Benefit Limits / Clawbacks :

During retirement, an individual’s retirement income will likely include payments from the Old Age Security (OAS) as well and the Guaranteed Income Supplement (GIS) programs, both of which are subject to income-tested clawbacks.  For the period of January – March 2011, the basic maximum Old Age Security payment amount is $524.23 per month. Recipients with incomes over $67,668 must pay back a portion of their benefit.  Your OAS repayment calculation is based on the difference between your income and the threshold amount for the year. You must repay 15% of that amount. This is often referred to as a clawback.

“Pensioners with an individual net income above $67,668 must repay part or all of the maximum Old Age Security pension amount”. “The full OAS pension is eliminated when a pensioner’s net income is $109,607 or above.” – Canada Revenue Agency
[OAS Rates]

For low income pensioners who earn little or no other income, the OAS is supplemented by a Guaranteed Income Supplement (GIS), which is considered non-taxable income. However, the amount of the GIS is dependent on income, marital status, and the age of the spouse or common-law partner (in couples). For the period of January – March 2011, the maximum supplement for a single individual with no other source of income is $661.69, and $436.95 to each spouse of a married couple. “To be eligible for the GIS benefit, you must be receiving the Old Age Security pension and meet the income requirements”.

In addition to OAS and GIS, those who contributed to the Canada Pension Plan (CPP) Retirement Plan will also receive a monthly CPP benefit. “The pension is designed to replace about 25% of a person’s earnings from employment, up to a maximum amount. For 2010, the maximum amount is $934.17” per month.  CPP benefit payments are also taxable as ordinary income.
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Future Changes To Benefits Are Likely :

It is important to note that current benefit eligibility requirements, payment rates, income thresholds, and tax rates are subject to change.  Government debts continue to increase and the social safety net is increasingly becoming a heavier tax-burden on the country.  Government run pension plans (federal & provincial) are losing money, over burdened, and will have to deal with a declining labour force.  It is likely that changes will have a negative impact and occur between now and retirement.

Likely policy changes include :
• Pushing the eligibility age for entitlements further back (i.e. higher).
• Clawback thresholds likely to become lower (i.e. clawbacks at lower income levels)
• Decreases to maximum benefit payment amounts.
• Clawback rates increase.
• Higher contribution amounts to national pension plans (but not necessarily an equivalent increase to benefit payments if even at all).
• RRSP to RRIF conversion rules.

The Canada Revenue Agency also mention that the OAS, GIS, and CPP  are adjusted for increases to the “cost of living”, as measured by the Consumer Price Index.  In 2009, I wrote an article regarding CPI and its relation to inflation.  There are many misconceptions including the CPI being a cost of living index.  Statistics Canada (StatsCan) and the US Bureau of Labour Statistics (BLS) specifically state that “CPI is not a cost of living index”.  A cost of living index differs from CPI, where the objective would be to measure price changes consumers would experience in order to maintain a certain utility level or a constant standard of living. Granted, it is difficult to make an accurate cost of living index.  However, it should be noted that benefit increases are according to CPI which is not a cost of living index.  This means that it is very likely that increase to your actual cost of living will out weigh and the increases to benefits received, or contributions made to government mandated/run pension plans.

The last few years has given us plenty of examples worldwide where a combination of pensions and benefits & services have been scaled back, while contributions have been increased, as well as eligibility ages pushed higher.

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Putting It All Together (Lowered Standard Of Living Or Pay More Taxes) :

It is apparent from all the clawbacks and threshold levels, that the government benefits mentioned above are meant for retirees with lower level incomes (else required to pay portions of it back). We can see that the combination of these benefits are not large enough to maintain most people’s current standard of living (while working).  Many people already feel that they can barely keep up with the increasing living expenses (energy, food prices, taxes, fees, etc).  Can you imagine that you would need to lower your current standard of living in the future? This means that you will need other sources of income, or draw down on personal retirement savings, all of which will impact your marginal effective tax rate. This is where the RRSPs are advertised as the retirement savings that would fill that monetary gap.  It is also why the government and financial institutions encourage that people should have a very large sum of money placed in them.   As we discussed, the age range of 65-71 is a very short time frame to withdraw such a significant sum of money from RRSPs, or be forced to convert them to a RRIF.  Income from other sources including CPP benefit payments will add to the tax problems.  It seems as though if you plan to live off anything more than $15,000 a year and have registered retirement funds such as RRSPs, the tax man starts rubbing his hands.  I guess $15,000 is okay if you don’t think you will own a home, need to pay property tax, want to have a car, go on vacation, etc when your 65.

Individually, these things seem okay, which is why I suspect that they are never discussed all together.  But when you put everything together, the combination is severely restrictive. So much so that it looks to me as though the government had planned to take more from you when you reach 65 years old.  By that time, it is likely you would be too old, tired, and already into the trap so deep it would be too late to reverse the years of contributions to Registered Retirement Savings Plans.

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RRSPs Are Not An Effective Long Term Retirement Program :

I don’t believe that RRSPs are an effective long term retirement program for everyone, especially if you are currently a low or middle income earner.  They are not suitable to be used as the main tool for investments and becoming financially independent either.  Contributions are locked in, unmovable, unusable, and can’t be used as emergency funds, which results in a loss of financial flexibility (a key to building wealth). You may want to seriously reconsider contributing to your RRSPs this tax season.  Investments gains and dividends (as well as losses) outside of RRSPs already receive preferential tax treatment, but when withdrawn from RRSPs, the entire investment amount will be taxed as ordinary income (not just the gains/dividends, and regardless of any losses). I didn’t get to where I am today through regular contributions into RRSPs.  The only time I have and would contribute to RRSPs is when my employer had a contribution matching program (getting free money from them).  However they stopped years ago, and I stopped putting money into it.

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Tax Free Savings Account (TFSA) :

I highly recommend taking advantage of Tax Free Savings Accounts (TFSAs) instead of RRSPs.  It allows individuals to contribute a maximum of $5000 per year, and any unused amounts are rolled over into the following year.  Contribution room is readjusted back (limited to $5000 per year in contribution room) for withdrawals made in the current year, but added on top of the following year’s contribution room (not for the current year’s limit). Inside the TFSA, investments can grow tax free, but the real advantage is in flexibility and the fact that there are NO taxes to be paid when withdrawn.  The only real disadvantage is that foreign income/dividends earned in TFSAs are subject to the regular foreign income withholding tax.  But that is a tiny price to pay for being able to keep much more money.  Each year I contribute the maximum amount that I can into the TFSA.  I believe that the TFSA is a tool that most people can truly use to become financially free.

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Know Your Tax Situation And Plan Ahead :

Everyone’s tax situation is different, and it really depends on your marginal effective tax rate at the time of contribution and when you plan to withdraw. There may also be special circumstances when contributing to an RRSP may make sense or be very beneficial, for a particular tax year (like pushing you down into a lower federal income tax bracket).  However, as a general retirement scheme, contributing to RRSPs over the long term is not something that will likely be beneficial, for low and middle income earners.  It will likely result in much higher taxes being paid.   I encourage people to think more deeply about their future goals, sources of income, and where they plan on being at retirement (financially) first. People should also think about their future marginal effective tax rate (the tax calculator at TaxTips.ca will help people to gain a better understanding of METRs) first, rather than contributing to RRSPs by default. To get a more accurate picture of how the marginal effective tax rates may impact your expected future finances and investments, work with a certified accountant and discuss your expected future tax situation.

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Some of you may recognize this article, which was originally drafted from an email I sent out to my investment partners, friends, & family, this time last year (January 2010).  In this version here I’ve expanded on the terms and definitions, and added the 2011benefit payment amounts for OAS and GIS, for the broader audience.  I hope that this information can benefit my readers here as well.  This year I noticed a significant increase in the number of national newspapers & blogs also discussing these misconceptions & drawbacks related to RRSPs. Its great that more Canadians are now being enlightened to all these untold drawbacks and limitations!  In a follow up article I’ll briefly discuss some ideas to help one decide how to get the most out of your RRSP or TFSA accounts, as most people have both.

Thanks and Happy Investing!  – The Investment Blogger © 2011
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