Your Questions: Saving and RRSPs

As the deadline for RRSP contributions approaches, we asked you about your savings plans.

Many of you said you use registered savings plans and tax-free savings accounts. Others question whether RRSPs are the best way to save for retirement.

We offered two members of our community an opportunity to put their biggest RRSP question to financial adviser, Jim Yih. Read their questions and Jim's response below.

RRSPs as a tax deferral

Roy (user RoyMaxwell) runs his own media consulting business in Burlington, Ont. He and his wife hired a financial adviser to go through their finances and savings because they "didn't want to make any mistakes."

The picture of the couple's net worth left Roy and his wife "stunned," Roy said.

"The impression is created that every dollar you manage to save is yours," he said.

"There's no such thing as a tax break; it's a tax deferral."

Roy's question is about the advice he should pass on to his 22-year-old son and 19-year-old daughter.

"Should they follow everyone else and get an RRSP?" he asks. "Or is there something better? There are a whole lot of things people don't think about.

"What is there other than an RRSP? Is it the only game in town? Are there other ways to go?"

Jim's response:

A lot of people share Roy's perspectives on RRSPs, especially people at the back end who are now drawing money out of an RRSP as opposed to depositing it. Roy is correct when he says an RRSP is a tax deferral. However, a tax deferral is a very good thing that, when used properly, can work to your advantage. Allow me to explain.

When you put money into an RRSP, you get a tax deduction equal to your marginal tax rate. When you take the money out, you will have to pay the tax back - but at the marginal tax rate at the time of withdrawal. If your marginal tax rate at the time of contribution is greater than your marginal tax rate at the time of withdrawal, then the RRSP works in your favour. If, however, your marginal tax rate at the time of withdrawal is greater than your marginal tax rate at the time of contribution, then you may have been better off doing something else with that money.

In my experience, most people will retire into a lower marginal tax rate than they had when they were working. For that reason, an RRSP makes sense for most people, though not everyone. Those who will not be retiring into a lower marginal tax rate should not buy RRSPs. The closer you get to retirement, the closer you want to evaluate RRSPs in this way.

As you get closer to retirement, planning is not just about whether you have enough. It's also about developing an income strategy to get money out of your RRSPs in retirement in the most tax-efficient way possible. It is almost impossible to pay no tax, but there are wonderful strategies that will help you pay less tax.

Advice for Roy's children

Let me start by saying how wonderful it is that Roy wants to give advice about money and RRSPs to his children.

I've always said that parents have a responsibility to talk openly about money and help children get a financial education because there are so few formal venues for that available to Canadians.

It is impossible to provide customized advice given the limited information in Roy's question but I can provide some issues for Roy and his children to consider.

• I believe the secret to Roy's children's financial success is developing a savings habit. It matters less what they put the money into - the habit of savings is key.  Have the kids create an automatic savings plan by putting away a fixed amount of money every month.

• Putting money into RRSPs is great because they promote long-term savings. The potential problem with alternative vehicles for savings, like Tax Free Savings Accounts and non-RRSP investments, is that there is nothing to keep the money there for the long term except personal discipline, which many people don't have. It's much more fun to spend than to save. RRSPs deter people from taking money out because when you do make a withdrawal, you have to pay tax. This deterrence can be a good thing.  

• To be able to contribute to an RRSP in the first place, Roy's children must have the contribution room, which is created by working. If they have no employment income they will not have RRSP room. In that case, the solution is to use a TFSA, a Tax Free Savings Account, instead.

• Let's say Roy's children do have contribution room and can put money into RRSPs, but their income is low, perhaps because they are in school, or working part-time or just starting out in the workforce. As a result, their RRSP deduction may not be worthwhile because it delivers little to no tax savings.  In that case, there are a couple of options.

• Make the contribution anyway and save the deduction for later, when the kids are in a higher marginal tax bracket. You can carry the contribution forward indefinitely, but remember that the longer you do, the harder and more important it is to keep track of the paperwork.

• Put the money into a TFSA first and transfer it to the RRSP later, when the kids can use the deduction.

Putting money into an RRSP also has benefits if the kids haven't bought a home but plan to do so in the future. The RRSP contribution allows them to get a deduction and, under the government's homebuyers' plan, take money out to help buy their first home. This is a strategy I preach often to people just starting out in the workforce.

In-kind contributions

Mike (user MG_123) and his wife live in Waterloo, Ont., and are expecting a child. They're saving 15 per cent of their take-home pay for retirement and use RRSPs and tax-free savings accounts.

Mike is curious about the tax treatment of in-kind contributions (transferring shares or savings bonds directly into an RRSP without cashing them in first).

Despite the wealth of RRSP information available online, he says he hasn't been able to find the answers he's seeking.

"I searched the [Canada Revenue Agency] website," he said. "It wasn't an extensive search, but I thought I'd be able to find something on it."

Jim's response:

First, I think it is great that Mike and his wife are saving 15 per cent of their net pay. I certainly do not hear enough of that.

An in-kind contribution refers to a contribution made by someone who owns a stock or mutual fund held outside an RRSP, on a non-registered basis. Let's say you own mutual fund XYZ outside your RRSP. You invested $1,000 and it is now worth $1,400. You can transfer the $1,400 investment into an RRSP in kind. The catch is that you must pay tax on the capital gain at the time of transfer. In other words, there is a $400 gain; you would have to pay tax on 50 per cent of that, or $200.

It is important to note that if the investment was down in value (let's say you invested $1,000 but it was now worth $800), you would not want to transfer that investment in kind because you would not be able to use the capital loss when making in-kind transfers to the RRSP. The better strategy is to sell the investment at $800 and trigger the loss. Then make a cash contribution to the RRSP and re-buy the same investment, assuming you wanted to keep it. The capital loss can be used against any capital gains: current, back three years or in the future.

If the mutual fund in our example is held inside a TFSA, then there is no tax because the TFSA is tax-free. Because the TFSA is so new, I am not sure if there is such thing as an in-kind transfer from a TFSA to an RRSP, but the investment could easily be sold and then a cash contribution made into the RRSP.

Mike needs to go to the financial institution that holds his RRSP to see if the investment that he wants to transfer in kind is eligible to be held inside the RRSP, as different institutions have different rules.

With the RRSP deadline only days away, Mike needs to know that in-kind transfers can sometimes take time to facilitate. He might want to borrow the money to make the RRSP contribution before the deadline and invest in the same investment he wants to transfer into. Once the investment is bought inside the RRSP, he can sell the investment outside the RRSP to pay off the loan. From a tax perspective there would be no advantage or disadvantage over the in-kind contribution.

Using RRSPs before retirement

Pam lives in Maple Ridge, B.C., with her husband and two children. She's currently unemployed and has some money saved in RRSPs.

She wants to know whether RRSPs are something that could help her now.

"If EI doesn't cut it, what are the downsides of taking some money out of an RRSP?" she asks. "Or should I stick with a line of credit?"

She's also curious about whether she can "make up for lost time" once she's employed again.

Specifically, she'd like to know whether it's possible to "get an employer to take more off the top than just your maximum [RRSP] deduction" if she hadn't made the maximum RRSP contribution in previous years.

Jim's response:

These situations are tough but quite common. It is impossible to provide customized advice given the limited information in Pam's question but I can provide some issues for Pam to consider.

Taking money out of RRSPs

The ideal time to take money out of an RRSP is when you are retired, in a lower tax bracket or spending the money to make your later years the best of your life. That's what the RRSP was intended for.

Although a combination of all three situations is ideal, any one of them can create an opportunity to withdraw money from an RRSP.  

In Pam's case, taking the money out when there is a tax opportunity to do so can have some merit. Withdrawing money from an RRSP when she has no other income means she could pay little to no tax on it. The RRSP must be in her name (not her husband's). If she has a spousal RRSP, which means her husband put the money into it in her name, the money must have been there for three years or he will have to pay tax. This is called spousal attribution.

Taking money out of the RRSP up to her exemption limit can cause her husband to lose some tax credits for a dependent spouse.

Line of Credit

I have some concerns about Pam using her line of credit. This strategy may provide a short-term solution but it has longer-term consequences. If Pam and her husband are living beyond their means, they need to either increase their income or cut their expenses. Ultimately, that may be the root of their dilemma.  

Pam needs to ask herself some tough questions about using debt to fund lifestyle:

• How long will this debt exist for? How long will it take to pay it back? If Pam can pay back the debt quickly, then the interest cost may not be too high. If this debt is going to sit there for a long time, it might be less expensive to pay the tax on the RRSP withdrawal.

• What is the interest rate on the line of credit? The lower, the better. The bigger issue is Pam's ability to pay back the loan. Will she be able to afford not only the interest but also the payments? Far too many people get into situations in which they spend money they don't have. Not only can they not pay the debt down, but it grows and grows. Pam needs to consider this and be realistic about the future costs of dipping into the line of credit now.

• How long will this subsidization continue? Dipping into the line of credit for a month or two is very different than using it to subsidize cash flow for a longer period. If that needs to happen, Pam and her husband need to take a serious look at their expenses and income.

Putting money back into the RRSP

Pam asked about making up for lost time once she's employed again. She can never replace the money taken out of the RRSP. That contribution room is lost forever and cannot be put back later. She will accumulate new room, which will allow her to put more money into the RRSP later, but she could have done that whether she takes money out of her RRSP or not.

The concept of time is an important one, because withdrawing the money now means that it is no longer working for Pam through the years. In that way, it is hard or impossible to make up for that lost time.

Jim Yih is a financial expert, fee-only advisor and professional speaker.

His goal is to help people make better decisions with money by educating them through his articles, books, audio CDs, videos and financial workshops. Jim brings financial education into the workplace as part of a holistic benefit plan for employees.