So this is pretty much the apex of the blog for the Canadian investor; the RRSP Articles! The deadline is exactly a month away as of this entry, so we need to start thinking about what the best strategy is for the RRSP. I'm going to try and spread it out over a few weeks, so we can look at the different features of the RRSP and what the most appropriate investments are for them.
Let's look first at a few points about RRSPs:
- Think of an RRSP as a piggy bank that we put money into. Once the money is in the piggy bank, we can use it to buy investments such as stocks, bonds, GICs and mutual funds, which remain in the piggy bank until we sell them and transfer out the cash again. We do not buy RRSPs; we open them (they are accounts) and then we contribute to them!
- When we put money into an RRSP, we can claim that contribution against any earned income from that calendar year. For example, if your income was $60,000 and you put $10,000 into your RRSP, then your taxable income goes down to $50,000. If you already had the tax taken off of your pay cheque, then you would receive the tax back that would have paid on the last $10,000 of your earned income.
- Here are the marginal tax brackets for Canadians for 2009;
http://www.cra-arc.gc.ca/tx/ndvdls/fq/txrts-eng.html
You may want to think about contributing the right amount to lower your taxable income into the next lowest bracket, rather than making large lump sums all in the same year. More on this later.
- Everyone has a limit to the amount they can contribute to an RRSP in a given year. For the 2009 tax year, that limit is $21,000. If you don't use all of your contribution room, then it carries forward to the following year and gets added to that year's new amount. Also, if you had additional contribution room from past years, then this would be added to your 2009 contribution limit.
- The limit is lowered if you contribute to a registered pension (teachers, nurses, etc.), as registered pension contributions count toward your RRSP contributions.
- You can find your 2009 contribution limit on your Notice of Assessment that you would have received when you filed your 2008 tax return.
- Most of our RRSPs are self-directed, that is, ultimately we decide what the investments are that will be bought in our own accounts.
- If we want to take the money out of our RRSP, that amount gets added to our taxable income for the calendar year in which we take it and we pay tax on it. Also note that if we take money out of our RRSP, we cannot put it back, unless we have additional contribution room. Moral of the story: try to avoid taking money out of your RRSP for as long as you can or at least until you reach a point where you aren't working any more, so your taxable income would otherwise be very low.
- Any investment income, dividends, capital gains is sheltered from tax once it is inside the RRSP. This, in my opinion, is what makes it such an effective investment tool. It, along with the TFSA are the only truly effective tax shelters, in my opinion. There are others but they always seem to come with strings attached.
Let's look at an example of the power of not having to pay tax on your investment gains:
If you had a $10,000 bond that paid you 10% per year which you reinvested into similar bonds, then without paying tax, you would double your money in 7.2 years, to $20,000.
However, if you had to pay tax on your interest income, your annual interest would drop from 10% to 6% (assuming a 40% tax rate). The amount of time it would take for your money to double to $20,000 would skyrocket to 12 years.
By that time, your $10,000 in an RRSP would be worth more than $31,000.
You might be thinking "yeah but what about when I actually want to spend it? I'll pay 40% tax and only have like $18,000." True, but that assumes you just blew the $4,000 tax refund you would have received for contributing to your RRSP in the first place!! If you had invested that amount as well at the taxable rate (assume 6%, as above), then you would be left with a total of about $26,000!! That's a full $6,000 more than if you never contributed in the first place. Ah, the power of the RRSP.
Here's a sweet strategy: Contribute to your RRSP (if you can max it out, all the better) and then with the tax refund you will likely get, contribute up to $5,000 of that amount to your TFSA!!! If you do both those things, you are on your way to success, because that means a huge portion of your invested assets are growing TAX-FREE. Then next year if you can't max out your contributions from your employment income, take the money that is in your TFSA and move it into your RRSP to make up the difference. Then, when you get the refund, put it back into your TFSA. Lather, rinse, repeat.
If you did this just once like the above example with $10,000, you would have $31,000 in your RRSP and $12,500 in your TFSA after the same 12 years. If you wanted all that money at once, you'd still have more than $30,000 after tax, since you don't pay tax to take money out of your TFSA. That compares to having just $20,000 if you kept letting the tax man take his cut each year.
The only trouble with my example is finding good bonds that pay 10%. This ain't 1984, people. If you don't get that joke, then ask your parents how they liked refinancing their mortgages in the early 1980's. In those years, you could actually find government bonds that paid about 15-20% per year, or close to it. Mortgage rates were similar.
I think I'll stop there for this week. It's quite a bit to digest. Please feel free to ask questions. There are no stupid questions; only stupid people. Just kidding. Email me if you don't feel like leaving a comment on here directly. If I get a chance, I'll answer it. If it's about what to buy with your contribution, hold that thought. I will touch more on that next week.
Adios!
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