Don’t get me wrong, I like RRSP’s. I make sure I am fully maxed-out every year. But there are a few things about RRSP’s that can work against an investor’s best interests. In particular, the way RRSP’s are promoted and sold turns what should be a carefully considered investment strategy into a feeding frenzy. So, I ask you, for just a moment, to ignore the advertising and the hoopla and to think a while about what makes an RRSP different from any other investment program. Then I’ll suggest some simple strategies which can help you get even better returns from this very useful investment vehicle.
The big strength of an RRSP is that it reduces the amount of income tax you have to pay. Any contribution you make to the plan is considered to be free of tax, and the compounded interest earned by your investments within the plan is also free of tax. But only as long as it stays in the plan – the obligation to pay tax is not removed, it is deferred. When you take money out of the plan your withdrawal is treated as income and taxed accordingly. If you refrain from dipping into the plan until you have retired, you’ll get maximum value because by then you’ll be paying tax at a much lower rate. That’s how the RRSP opportunity should be used.
Unfortunately, in my opinion, the Government which gave us this excellent incentive to save for retirement is encouraging people to sabotage their own plans by using them for something they were never intended for. That second R stands for Retirement, remember? It does not stand for Real Estate, it does not stand for Reading, Writing and ‘Rithmetic. The various Registered Home Buyer and Educational Plans that are offered by financial institutions and other promoters all undermine the true intent of the RRSP by taking a substantial sum of money out of the plan, where it should be compounding away on your behalf, and using it for a quite different purpose. In theory that money will eventually be returned to the plan, but it may take many years. Years in which you are preventing your plan from doing the one thing it was set up to do – to achieve the long-term, tax-sheltered growth that’s necessary to build up a respectable retirement fund.
If a client of mine is in need of cash for a house purchase or for additional educational pursuits I do my best to find some other source. Borrowing from an RRSP is stealing money from your own future.
So, I promised you some tips on how to squeeze a little higher return from the Canadian Government’s big incentive to save — the RRSP. Here are three, to start with.
Ø Don’t wait until the last minute to make your contribution. That way, you forfeit a year’s worth of tax deferral. If you can, invest the whole sum as early in the tax year as you can; if not, make a smaller contribution every month. Each payment will begin earning, and compounding, from the moment it is invested.
Ø When the tax refund generated by your RRSP contribution reaches you, don’t just spend it. Reinvest it, in the RRSP. You will have increased your annual RRSP contribution by that amount — and will get an even bigger refund next year.
Or you could borrow money, temporarily, to increase your contribution. Let’s say you are in the 50 per cent tax bracket, are planning to make a $2000 contribution, and have “catch-up” contributions still unused. Sometime early in the year you borrow another $2000, and make a $4000 contribution. You’ll receive a $2000 refund, with which you pay off your loan. So you have no refund, and you’ll pay a few weeks’ interest on the loan, but there’ll be an extran$2000 in your plan, earning and compounding. I should remind you here that when you borrow money to make regular investments, you get tax relief on the interest on your loan. But if you borrow money to top up your RRSP, you do not get that tax relief. That’s why I suggest you keep the period of the loan as short as possible.
One last thought. There is one circumstance under which I would say do NOT invest in an RRSP. It’s if you are carrying a heavy load of debt — car loans, credit card loans, second mortgages. In that case your best possible investment would be to clear the loans, starting with the ones carrying the highest interest. Then when you are debt free, it’s time to take a close look at the potential of an RRSP. Preferably under the guidance of a financial planner.