Tax Season

Registered retirement savings plans aren't for everyone

RRSPs may not be the best choice when it comes to long-term investing and sheltering money from tax

Registered retirement savings plans have long been a standard tool for average Canadians saving for their golden years. But are RRSPs the best choice when it comes to long-term investing and sheltering money from tax?

For years, the RRSP has been the government's main subsidized-investment vehicle as contributions reduce one's taxable income, dollar for dollar.

But Ottawa's new tax-free savings account, established in 2009, injected a little more choice for savers. The TFSA allows you to save money and have it grow tax-free. You can also withdraw interest and investment income from the new account at any time without paying any tax on the principal or interest, something not available under the RRSP system.

'For low-income and modest-income workers, saving in registered retirement savings plans … is not a good option.'—Canadian Chamber of Commerce

The new savings account has also brought into focus flaws within the RRSP program, some of which affect many people, experts say. Even the Canadian Chamber of Commerce has had some harsh words for the country's RRSP system.

"For low-income and modest-income workers, saving in registered retirement savings plans … is not a good option," the Ottawa-based business group said in a recent report.

Few young people save

Perhaps the first hint that the RRSP might not be the ideal savings vehicle many assume it to be can be gleaned by the fact that few Canadians actually put money away for retirement.

In September 2009, a TD Canada Trust survey found that 80 per cent of Canadians said they found saving money "too hard."

Among Canadians aged 18 to 34, only 19 per cent of respondents said they saved 10 to 25 per cent of their income — fully 10 percentage points fewer than savers who are 55 years or older. (The survey was conducted by Angus Reid Strategies from July 24 to 29, 2009, and asked 1,001 men and women in three age categories — 18-to-34, 35-to-55 and 55 plus — about their savings habits and perceptions).

Older worker woes

Of course, a person's individual circumstance often dictates the ability to save. But when Ottawa introduced the RRSP program, the government also believed the publicly assisted account would stimulate savings across all age and income groups.

It turns out that men and women approaching retirement age are not much better than younger people at squirreling away their loonies.

A recent poll conducted for the Royal Bank of Canada indicated that fully one-third of all Canadians had no retirement savings. (The RBC survey of 1,457 adult Canadians was conducted online by Ipsos Reid between Oct. 21 and Nov. 2 and has a margin of error of plus or minus 2.56 per cent.)

Worse still, in 2009, only about half of Canadians 55 years or older said they have had made retirement plans. And this is the cohort that is getting set to retire, has the shortest amount of time in which to accumulate savings and should be the most interested in RRSPs.

Timing

There are a few reasons why RRSPs have failed to generate the level of savings that Ottawa had hoped, experts say.

RRSPs are best for individuals who believe they will face a lower personal tax rate when they retire than when they are making their savings contributions.

But younger people, who likely have smaller incomes when starting out in the workforce than they will have later on in their careers, are probably better off not investing in an RRSP and instead should be putting their cash into a TFSA, personal finance experts said.

"In situations like this, you may want to consider contributing to a TFSA this year and save your RRSP contribution for the future, when you are in a high tax bracket," said Chris Dyer, BMO Retail Investments' regional sales manager for Manitoba, northwest Ontario and Saskatchewan.

Indeed, that issue is more acute for individuals who earn a relatively modest income throughout their working lives but are diligent savers, experts noted.

In that case, the RRSP tax break might not be very valuable during their careers. Indeed, the maximum annual deduction — the lesser of 18 per cent of your earned income or $21,000 — might only generate a small yearly tax deduction for modest-income Canadians.

Then, as the RRSP accumulates over time, a worker could wind up withdrawing more money in yearly cash when they retire than they made in an annual salary. These people would face a higher tax rate when they take money out of their RRSP than if they had just placed the same amount of cash in a TFSA.

That would leave them paying more tax on their retirement income than they saved when deducting the original RRSP contributions from their working salary.

Life changes

Besides shifting income levels, younger people may have differing life priorities when they first enter the workforce than when they are older. And those differences might be reasons to ignore RRSPs, said David Trahair, a Toronto-based author and RRSP critic.

For instance, a newly married couple might want to buy a house.

In some cases, paying down a mortgage can generate better return-on-investment than an RRSP.

One well-used strategy would have them borrow to invest in an RRSP and use the subsequent tax deduction to pay for either the down payment or the mortgage payment on a new house.

With only a modest income, however, the couple would generate an equally limited RRSP. The result would be a small down payment or mortgage payment for that new home.

In addition, young savers are likely to place a large portion of their RRSP money in stocks, since this is the time in their lives when they can take on the greatest amount of risk in their portfolios. But Trahair noted that management fees on the stock purchases ultimately cut the return on RRSP investments.

For example, a two per cent investment fee will cut a six per cent equity gain down to four per cent.

Meanwhile, if the couple's mortgage is, say, five per cent, they get an implied five per cent return by paying down their mortgage rather than the four per cent from an RRSP investment.

In such cases, it makes more sense for young couples to use the cash to pay off the mortgage and ignore an alternative plan of holding equity investments within the RRSP, Trahair said.

Deduction versus tax paid

Savers also need to ensure they match the value of their RRSP deduction with the level of personal income tax they face, financial planners said.

For example, in a year, a person might have RRSP contribution room — the government limit on your annual contribution — worth $10,000. But suppose the individual will only pay federal tax of, say, $7,500.

Instead of contributing the full $10,000 into contribution room, the person should only stick $7,500 into his or her RRSP. The extra $2,500 in additional RRSP room can then be carried forward into other years when income may be higher, experts noted.

Pension paydown

And not everyone has the same RRSP contribution room.

For those Canadians who are members of an employer-sponsored pension plan, government rules reduce most of their RRSP room, according to author Gordon Pape.

That is because Ottawa will cut your available RRSP contribution limits, based upon the size of your company or institution's pension. This calculation is called your "pension adjustment."

"People in higher income brackets may find they have little or no RRSP room left after the [pension adjustment] has been deducted," Pape wrote in his 2009 book, Tax Free Savings Accounts.

Thus, the government will reduce, and in some cases eliminate, the RRSP tax break for those nearly six million Canadians who were members of a pension plan in 2008.

More taxing problems

Worse still, Canadian retirees who have even modest RRSPs totalling less than, say, $100,000, face a potentially huge hit to their income once they quit working, said Richard Shillington, a social policy consultant and RRSP critic based in Manotick, Ont.

That's because Ottawa taxes back one of its major support payments for seniors — the Guaranteed Income Supplement (GIS) — if the retirees earn more than $15,000 a year, he said. And RRSP withdrawals count as income.

'Put your money into an RRSP, but make sure you get it out before you are 65. Basically, you don't want to be in an RRSP if you are getting GIS money.'—Richard Shillington

Shillington, who has written three notes for the C.D. Howe Institute outlining his RRSP criticisms, said the median income for Canadian seniors is in the range of $15,000, through a combination of Canada Pension Plan payments, the Old Age Security money (OAS) and GIS money.

The last two programs are government payments that boost the income of poorer seniors.

Ottawa, however, begins "clawing back" — or taxing back — the GIS supplement at very modest levels of income, Shillington said. And the payback rate is typically 50 cents in additional taxes for each dollar of GIS the man or woman receives, he noted.

So a person with a modest RRSP upon retirement could lose a big chunk of their GIS as soon as they begin to withdraw money from savings.

"Put your money into an RRSP, but make sure you get it out before you are 65. Basically, you don't want to be in an RRSP if you are getting GIS money," Shillington said.

He estimates that about 38 per cent of retired Canadians receive GIS payments.

"This is not a fringe group," Shillington said.

So, add together lower-income Canadians who have little incentive to use RRSPs and the 38 per cent of seniors who receive the GIS, and you get a pretty substantial number of citizens for whom the RRSP is of little or no value.

"They are being promised benefits that will never materialize. Why? Because the tax advantages they have been promised from their RRSP will be wiped out by reduced benefits," Shillington says.

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