Olivia has long been a fan of RRSPs, even preferring them over TFSAs for a lot of people.
Basically, her logic goes like this. As long as you’re making a decent amount of money, you’ll trigger a nice immediate tax refund by investing in your RRSP. That refund can then be reinvested. If you’re in the 25% tax bracket, it’s basically like getting a 25% guaranteed return and then you get years of compounding on that return.
To really illustrate the power of this, I use the financial calculator:
Current Principal (PV) $10,000
Annual Addition (PMT) $0
Years to Grow (xP/YR) 30
Interest Rate (I/YR) 8%
Compound Interest Time Annually (P/YR) 1
Make Additions At start of each compounding period
Future Value (FV) CALCULATED RESULT $100,626.57
Next Year she received the refund of $2,500 and reinvested it to RRSP again.
Current Principal (PV) $12,500
Annual Addition (PMT) $0
Years to Grow (xP/YR) 29
Interest Rate (I/YR) 8%
Compound Interest Times Annually (P/YR) 1
Make Additions At start of each compounding period
Future Value (FV) CALCULATED RESULT $116,465.94
Reinvesting $2,500 of free money turns into an additional $16,000. All she has to do to make that money appear is to reinvest her tax refund, which she only got from contributing to her RRSP in the first place.
It’s truly amazing.
If she does this for a 10 years she can really see how immediately reinvesting that tax refund starts to add up. All it takes is a 10-15 years of investing a decent amount when she is young to ensure there’s enough for retirement.
But we often forget about what happens once you hit retirement age. That cash has to be taken out, which becomes a problem if you’ve got a 1Million or 2 Million sitting there. Not a big problem. Just how can you deplete your RRSPs without paying a boatload of tax?
Olivia has been thinking about this lately. She first started contributing to her RRSP as a 15-year-old lady with cash from her first job. That contribution was approximately $500.
Remember, there were no TFSAs back then. So she continued to contribute despite not having much of a tax liability. She consistently put her money away over the years to the point where she is now sitting on some pretty solid RRSP assets.
She has crunched the numbers and if she compounds these assets at 8% for the next 30 years — which is when she will hit the traditional retirement age — she will have well over $1 million in just RRSPs alone. She should also have another $1 million from her TFSA, which she plans to max out annually for as long as she can.
She has also got stocks and other investments outside of these registered accounts.
So what’s Olivia to do?
The problem with all this is she is looking at big tax bills when hits age 65. She guesses she can delay it until age 71, when she‘ll be forced to contribute 4% of the portfolio.
Say it’s worth $1 million even. Olivia will have to withdraw $40,000 per year that first year and then even more going forward. If she has a portfolio spinning out lots of tax-efficient dividend income (which is the plan) of $40,000 per year — which is fully taxable — to say $50,000 gross up in dividend income, she is looking at a relatively high tax rate. If Olivia had taken professional advice, her investment income would not have contained dividend income, which in retirement is not a bonus, but a minus. Using the suitable “retirement” portfolio, and other tax strategies it could save significantly on taxes.
Considering savings rate today and having 30 years of growth ahead of us we could have $150,000 to $200,000 in household dividend income by the time we hit retirement age.
It was valuable to defer tax when Olivia was younger. But the more we look at it the more we realize deferring tax is no longer the right answer for us in older years. It will likely only contribute during heavier taxed years going forward, choosing instead to channel savings into TFSA and taxable accounts.
You can over save for retirement
Somebody who blindly invests the maximum into their RRSP for their entire 45 year working life is doing it wrong. They’re going to end up with a massive amount of money set aside that’ll all have to be withdrawn at a high tax rate.
The better strategy is to end up with a moderate amount in your RRSP and go to maxing out your TFSA.
But at the same time, this only really applies to the very small percentage of the population that has consistently maxed out their RRSPs as a young person. If you’re 40 and are sitting with $25,000 in your RRSPs ignore this whole post and put in as much money as you can afford. Your problem is saving enough for retirement, not avoiding tax caused by over saving.
Tell everyone!