RRSP First Principles

[I am, if not my worst critic, at least my most diligent, and so I am now quite convinced that my last missive on the subject of personal finance was sorely over-ambitious. There was enough there for at least 4 posts, and I crammed it all in. Instead, I’m going to try to lay this stuff out more smoothly, because I really do think it’s important. Let me know whether I’m making more sense.]

Cutesy giggles about not wanting to grow up notwithstanding, when you leave school and start working full time, I believe you reach a point where you can be reasonably expected to take some ownership over your life. Paying your own bills, washing your own laundry, these are the things that distinguish us from lemurs. There are, of course, plenty of good reasons to temporarily take a pass on these: people living with their parents to help save up for a downpayment are being relatively grown up about their lives, for example, even if they aren’t paying their own bills just yet. But in general, we expect people to sort of become adults. The problem with this expectation is that unlike driving, or parenting, or trigonometry, there is not a coherent attempt during most kids’ lives to teach them anything about money, and since the same was largely true of our parents’ generation (perhaps moreso), a lot of people get to be adults without knowing much about how to manage their money or how to save for the future. The problem is that this uncertainty evolves into embarassment, which becomes denial and refusal to do anything about it, and that’s no good because eventually someone has to pay the bills, and this thing where we just hike the Canada Pension Plan premiums by 5-10% every year isn’t going to keep working.

What I’m going to try to do here is just talk through the idea of an RRSP, in the hopes that you’ll at least come out the other side confident that you know what an RRSP is, so that you can start thinking about how you’re going to go about building one. There is good discussion to be had about the relative merits of RRSPs vs. other investment possibilities, but none of that can happen until we are working with some shared understanding about the ground rules, so don’t sweat that. As I mentioned above, I’m also not going to try to offer advice on which products to choose here, since it takes us back down the road of a post too long for any mortal to read. So here we go…

But Enough about RRSPs

Before we talk about RRSPs, let’s talk about the more obvious stuff. Let’s say that you’ve decided you’re going to start putting away 10% of every paycheque towards your fabulous and wealthy future. This is already a good start, and because we’re starting simple, you’re just putting this money into a chequing account. There was a time when a nice safe account that could just hold your money for decades and still have it there at the other end would have been a damned fine little idea. These days though, people have realised that money can be doing work while it’s sitting there, and growing into more money. Of course everyone’s already seen a compound interest graph but because they are such happy things to look at, here you go:
Compound Interest Graph

So let’s say that instead of putting this into a chequing account, you put it into some interest bearing savings account. Most banks pay pretty crappy interest, but a place like PC Financial should at least give you a couple percentage points. $3 on a $100 isn’t very exciting but on the other hand, if you’re going to have $10,000 in a retirement account somewhere, you might as well take the free $300. My hope is that so far you’re nodding.

So. 3%. To get much more than that, you have to start taking risks. Canada Savings bonds pay a teensy bit better than one of these interest earning accounts because they have to reward you for the fact that you are locking up your money, typically for a 5yr term. Maybe you don’t see much risk that the government of Canada will default, but there is risk, in the sense of lost opportunities, in locking up your money. You can buy bonds from other countries, and the riskier ones will tend to pay more, commensurate with the risk. Ditto corporate bonds. You can buy stocks which, historically, have done pretty well in terms of growth, more than 10% per year on average, but which can be very volatile in the short run, maybe enough that you don’t enjoy investing any more, and stop saving. That’s bad, but don’t get antsy because remember, we’re not talking about investment strategies here, we’re just talking RRSPs. So are we all agreed that there are all sorts of interesting things to put your money in, with varying levels of risk and return?

Good. So the problem is, the government figures that if you’re getting dividends from a stock, or interest from a bond, or even interest in your little PC Financial savings account, that’s income, and you owe tax. You might not pay any tax today on the $0.12 your bank gave you last year, but believe me, revenue agencies are quite positive that interest is income, and if the amount gets high enough, expect them to come knocking. Taxes on government bonds, stock dividends, sale of goods at a profit, and other investment transactions can get complicated, but the moral is that in the end, the tax man cometh. And that sort of sucks because you were trying to do a good thing saving for retirement, to stop being a burden on the public support system and to build yourself some security, and now the government is taxing your interest. “But what about my compound interest graph?” you cry! It sucks, and the sad thing is that the government agrees that it sucks. The problem is that the government can’t tell from looking that you intend this or that account to be for retirement (with which they would like to help you) instead of for a new cheetah-print chaise lounge (with which they pretty much figure you’re on your own.) What you need, regardless of what kind of investment you’re making, is a big rubber stamp that says “This account is for my retirement. I’m not going to touch it until then, so leave it alone.”

An RRSP is a big rubber stamp that says “This account is for my retirement. I’m not going to touch it until then, so leave it alone.”

An RRSP isn’t any one thing — calling an account a Registered Retirement Savings Plan just means you would like to not pay taxes just at the moment, thankyouverymuch. There are RRSP versions of everything we’ve talked about. There are RRSP simple-fixed-interest-rate accounts just like PCF (in fact, PCF sells one). There are RRSP bond accounts. There are RRSP stock trading accounts. If you are willing to pay a tax lawyer to draw up the paperwork, you can even hold crazy stuff in there like mortgages and such. Most of the time, and for most people, if it’s an investment, you can paint it with the RRSP brush.

Of course, most of the time it’s too much hassle to fulfill all the regulatory requirements yourself, which is why every financial institution is willing to do it for you. A stock trading RRSP account at TD Waterhouse, for instance, looks no different than a non-RRSP one. The difference behind the scenes is that TD is doing paperwork to register the account for special tax status, and out in front, the difference is that you don’t get to make withdrawals until you retire. Other than that, it’s the exact same kettle of wax, so to speak.

The Payoff

So why put your money into a registered account instead of a regular one? I’ve mentioned tax breaks, but not the specifics. There are actually two ways the government cuts you a break on your retirement savings. The first one is what we’ve talked about already, namely that while your money is in an RRSP, any growth you get through interest, capital gains, dividends, whatever — none of that is taxed, it’s just added to your RRSP’s magic compound interest chart. This actually makes investing much simpler because if you do all this investing on the outside, you have to calculate how much tax you owe on each different kind of investment income. Inside the RRSP the answer is always, in the immortal words of those awful Fido commercials, “Zeeero Dollarrrrs.”

The second bonus is that you get the tax back from the money that you’re contributing to your RRSP, that 10% of each paycheque. That is, since the government wants to reward you for planning ahead, they say that any money you contribute to your RRSP, you can deduct from your “total income” on your taxes, meaning that the income tax your employer charged over the year is now too much, meaning you get a refund. Of course, the lucky best super thing to do with this refund is roll it back into your RRSP. Doing this is sometimes called the “Ladder” approach because it helps you build your contribution every year, watch:

  • In year 1, you contribute $100 per paycheque, 26 times a year: $2600 total. On year 1’s taxes, you get a refund of, say, $800.
  • In year 2, you keep contributing $100 per paycheque, 26 times a year: $2600 total. You also add the $800 tax refund from year 1. Total contribution: $3400. Refund in year 2 is around $1000. Total RRSP is now $6000 plus hopefully some growth.
  • In year 3, you still don’t increase your contributions, another $2600, plus the $1000 from year 2 taxes, $3600 total. Refund $1100.
  • Every year, even if you don’t increase your regular contribution, your total contribution and refund keep climbing. Plus maybe you’ve gotten a raise, so 10% is a bigger amount of money. Plus your money is growing tax free while it’s in there. Hooray!

Afterthoughts

It is not technically all roses and sunshine. For one thing, when you retire and take your money out, NOW the government taxes it. The pitch is that you’re probably not in the same tax bracket anymore, so you’re paying less tax, and hey, even if you aren’t, you got refunds for 30 years, you got tax free growth for 30 years, so whaddya want, jackass? If you take it out before you retire, the government gets rather irate and hits you with a penalty on top of the taxes. The good news here is that some of the obvious things you would want it for: buying a house, going back to school, etc, have their own special cases defined. Still, the best story is that you find other money for those things, and keep your RRSP growing quietly but constantly in whatever vehicles you choose to invest it.

There is also discussion about whether it would be better to just ignore RRSPs, invest in normal accounts, pay your taxes, and profit from the broader range of options. This is a fine thing to talk about over a nice glass of cognac, but investing outside an RRSP can really be tax hell. Income from a real estate income trust, for example, is broken down into at least 4 different types of income for tax purposes. For someone just getting started, I would recommend avoiding all that. You can always open up non-registered accounts later if you decide they are your bag, baby.

The final bit of good news is that you can usually (service charges, pension/locked-in plans, and other irrelevancies notwithstanding) transfer money between your various registered accounts without the government getting annoyed. This means that, even though we haven’t talked about investment strategies or diversification or efficient markets, you can still start today. Get yourself set up with one of those boring 3% no risk RRSPs today, start depositing, and later, when you’re more comfortable with actual investing you can either move money around, or just start depositing to a different account and leave the existing one there to grow slowly but safely.

My hope is that after all of this, you sort of “get” RRSPs and the fact that they’re really not a new kind of beast, they’re just tax-simplified. As a final note, the reason you are hearing about RRSPs so much right now is that rather than cutting off at December 31st, like most tax things do, the government gives you two extra months to recover from any leftover Kwanzaa spending before it officially closes the books on 2005 (or whatever year just ended, whenever you’re reading this.) So you have until March 1 to look at setting up an account. Obviously you won’t have much to throw at it, I always think it’s funny when banks talk about where to put your “RRSP deposit,” like the only way to do things was as a single enormous lump. It’s just a bank account with a special stamp, contribute to it however the hell you want. But please please please, contribute to it.

6 comments

  1. You know that if you plan your RRSP contributions in advance, there’s a little form you can give to your employer that says “I’m going to deposit X into my RRSP, so you just go ahead and take Y amount less off my paycheck as tax, thank-you-very-much. That way, rather than paying tax and then getting it back, you can just not pay it in the first place. That way, instead of investing $2600 in year 1, you can invest the $800 tax return you would have made on that, plus the $200 tax return you would have made on that, the $50 you would have made on that, etc., up to say $3500, and still only take home a total of $2600 less on your paychecks.

  2. Indeed – your money is working sooner and the balance looks like it’s going up faster too. I always struggle when I write articles like this, because there’s all sorts of good information to get out there, but I already write longer than most blog posts and the greater risk I think is people getting tired before they reach the bottom. I hope that if there are readers out there who decide to get cracking on their RRSPs as a result of articles like this, that they might stumble onto these little optimizations on the way, but short of breaking out a separate “21 interesting RRSP factoids” article, which might indeed be a good one to write, my attempt to keep the word count down won out over mentioning items like this.

    Which is why I am grateful to have you mention them in the comments, where others might read them and not blame me. 🙂

  3. I’m curious about the “penalty” that you refer to about withdrawing money from an RRSP before age 69. I can’t seem to find any documentation on this. Taxes on the income, yes. Penalty, no.

    I have found that the government will “withhold” a certain amount of tax on RRSP withdrawals, the amount depending on the amount withdrawn (see http://www.theglobeandmail.com/series/rrsp/2005/neat.html for details). But that’s just them doing the same as any employer, grabbing the government’s tax cut early. You then end up having to pay the balance of the taxes.

    So, in a lean year, if you’re not making any money, you can take money out of your RRSP at will, but you’ll have to pay taxes on it when you withdraw. If you’ve got evidence to the contrary, I’d love to read it!

  4. Ephraim – you’re right that the withholding can be thought of just like an employer’s front end tax and it is a mis-statement to imply that there are additional fiscal penalties charged. There is, however, an additional downside to making early withdrawals in that you don’t get the contribution room back after doing so. A lot of people who make this move are in relatively dire straits too, and should be aware that when their RRSP balance says $10k, that doesn’t mean they can have $10k tomorrow if they cash out. As you say though – as a deliberate and thoughtful supplement to a low income year the “penalties” are no more than you should rightly expect them to be in terms of tax on income.

  5. I would simply like to say thanks for the posting of this blog! I’m 24 years old and have found myself in a position where I no longer have the excuse “I don’t make enough to invest in the future”, and also have been frustrated about hearing how others have ultilized the RRSP tax system to reap excellent returns, whereas I have not. I found this to be an excellent high level overview above everything I’ve read to date around this topic put in a way that easy to read and retain (and even somewhat entertaining) with an appropriate length as I can take this and investigate specifcs from it furthur.

  6. Interest-Bearing

    Glad to see someone is staying on top of things.