Continuing from Part 1 and Part 2, it’s looking like saving for retirement through RRSP’s versus non-registered portfolio savings is almost neck and neck – albeit having made some fairly large assumptions.
Namely, we assumed that Anna can afford to pay the tax bill on her non-registered portfolio up to age 65. This may not be the case if she held individual securities or mutual fund trust units as the interest income, dividend income and realized capital gains distributions could be in the tens of thousands of dollars per year at this point. We cannot just arbitrarily pull money out of her day to day cash flow to pay these costs in one scenario and not for the RRSP savings scenario as well.
Unless… Anna had been investing in Mutual Fund Corporations. In today’s day and age, the fund shelf of corporate class mutual funds offered by the larger mutual fund companies allows for a diversified portfolio all held within the corporate class structure. For example, a balanced portfolio (70% Equities, 30% Fixed Income) offered by *Name Withheld* Investments has not made a taxable distribution in 9 years according to an inside sales rep I just got off the phone with. In addition, the corporate class investments can be switched to the T-Series version of their funds when it is time to make withdrawals and as much as 8% per annum can be withdrawn as a Return of Capital – which means there would be no tax on up to 8% of your total invested capital per year for withdrawals. The Return of Capital distribution would slowly grind the ACB of your portfolio to $0, at which point all the remaining withdrawals would be taxed as capital gains – but this would take many years. This structure of non-registered investments is hard to beat for long time frames because of the special tax-advantaged structure.
I will analyze the cost of using tax-advantaged Corporate Class Mutual Funds versus lower cost (and higher yielding) investments in another post on this blog – I don’t want to go too far off on a tangent just now…. :)
Getting back to Anna… let’s look at the case of her not using tax-advantaged investments first. In this case, she has an ever-growing tax bill that she has to pay every year. I will assume, to make a proper apples to apples comparison, that she pays the tax bill through withdrawals from her non-registered portfolio. Just by doing that, her retirement income drops tremendously to $42,075. This is below even the level of income afforded by saving to an RRSP and NOT using the tax refund productively.
If she were to use tax-advantaged investments (i.e. corporate class investments), then her annual income would be closer to (and higher than) the $51,300 originally calculated since her withdrawals in retirement would also be a Return of Capital first, before triggering capital gains many years later.
So in this case, using the tax-advantaged investments in a non-registered portfolio can make a huge difference. In fact, if you have long-term, non-registered investments you should do your own analysis (or have a professional prepare one for you) to compare the extra costs involved versus the tax-preferential treatment. You *might* save more in tax than you pay in extra costs.
Getting back to the second question we wanted to address: What if there is part-time income in retirement? So far, we have just assumed that the retirement savings in all cases was the only source of income. But many people today are smoothly transitioning into retirement rather than stopping altogether. In fact, I have had more than one client retire and then go back to work part time to keep them from going stir crazy!
In this case, we need to remember that all RRSP withdrawals (or RRIF withdrawals) are taxed as income. If a person also has income from a job, it may not be necessary to withdraw money from the registered accounts, but in some cases you may be forced to do so. For example, once you turn 71, you must mature your RRSP. The most popular maturity option is to convert the RRSP into a RRIF account (a registered retirement income fund). RRIF’s have minimum withdrawal amounts that you must adhere to, even if you don’t need the money.
If your income from employment is enough to cover your expenses, then withdrawing funds when you don’t need to will only attract taxes that are best left deferred if possible.
The problem of too much money in registered accounts is NOT an uncommon one. It is the very reason RRSP/RRIF meltdowns exist. Another example to stress the importance of retirement income planning is for people with defined benefit pension plans. If you have a substantial pension plan, you may not want to save to RRSP’s at all as both RRIF income and pension income is taxable. With a defined benefits pension, you have very little (if any) control over the payment schedule.
Always keep an eye on the future when making decisions today.
Don’t believe me? Just visit a senior’s centre and ask for anyone who has an opinion on OAS Clawback. (OAS, or Old Age Security, is a Government benefit that is income-tested – which means that it is subject to clawback if your taxable income is above a certain threshold.)
Having said all that, does this mean you should abandon your RRSP savings strategies? NO, not at all. It just means you have to be aware of certain situations that can make saving to an RRSP less attractive. I would say that for maybe 50% of people (just a rough guess), saving to an RRSP is the best thing they can do. Maybe for a further 25%, it may warrant a closer look (which may result in a reduced saving, but not a cessation of saving to the RRSP). And for the final 25% of people, it may not be a great idea after all (big pensions, other sources of income in retirement, etc.)
I really can’t stress enough how important it is to make retirement income projections.
Using your RRSP Refund Effectively
Take all the analyses performed with a grain of salt. How many people actually use 100% of their RRSP refund towards re-investment? Certainly not everyone. This will dramatically change the results from a dollars and cents perspective. But what about psychologically? If someone used their tax refund for personal consumption, is that such a bad thing? Some would say yes, some would say no.
Psychologically, some people make bigger RRSP contributions just so that they can receive larger tax refunds. For some, a fat "Credit Owing" is a powerful reinforcer for savings behaviour.
Final Thoughts
Finally, we also haven’t looked at putting the RRSP refunds against your mortgage in this set of posts. Nor have we looked at tapping into tax-free home equity. So certainly this analysis is not exhaustive.
Hopefully though, I have given you some food for thought when next reviewing your financial plan with respect to the importance (and intricacy) of retirement income planning.
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Could you do one more scenario where the person gets a company match of 4% of their salary so they put 4% on their RRSP in to income producing assets (8% total including the match) and then also puts 6% in to equites outside the RRSP. This would keep all interest income taxed at it’s appropriate level and keep the capital gains and dividends outside the RRSP to be taxed at the current level of income.
The answer I’m looking for is: "If your company matches, JUST DO IT ALREADY!" . . . I’m assuming it will work out for the best but would like to see it first hand included in the possible outcomes.
If your company matches, JUST DO IT ALREADY!
:)
But I will work through that and post the results – hopefully tomorrow.
Preet
Great series – a lot of work!
It amazes me how even a lot of people (even bloggers) think that the rrsp is not a good idea because they "have to pay all that tax at the end". Clearly they don’t understand the differences between rrsp & non-reg accounts and using pre-tax and after-tax money.
As for the "too much $ in the rrsp" problem – I just can’t figure this one out – do these people blindly work until 65 and then realize at age 71 that they didn’t have to? All it takes is a bit of planning.
Mike
Hi Mike, thanks for the kind words.
Unfortunately, there are many people who are very intimidated with their finances. They may not have the same inclination as we do to learn enough to be self-sufficient.
You would be surprised at what the general level of finance knowledge is out there – it is EXTREMELY low on average.
It really needs to be taught. I’m going to be writing a book on personal finance basics (hope to be published Q42008) and maybe one day write a textbook for high-school level material.
Traciatim: For your requested scenario, I omitted getting a refund since if you are getting company matching, they are probably reducing the withholding tax at source.
Nonetheless, and assuming corporate class investments, our sample investor would be living the high life with $58,750/year after tax, in today’s dollars with a probability of success of 75%. Her probability of success of withdrawing $43,700/year in that scenario jumps up to a whopping 94%.
Compared to the other scenarios, this is hands down the best way to go. It is NOT apples to apples as you know since there is the free money added from the company matching.
Nonetheless, I hope this answers your question more definitively.
Preet
Thanks for including my scenario. It’s nice to actually see how much of an advantage this scenario brings. It also make me feel great that my company matches 6%. I only contribute up to the max that they match, as they have very little choice of dunds (5 to be exact).
I really need to get on getting my other 6% in to a self directed fund somewhere. Maybe that will be my 2008 goal once I get my yearly review/raise, to put 6% more in to a self directed RRSP.