Scenic cruises. Road trips. Never having to wake up early for work again if you don't want to.
If your retirement years are supposed to be your golden years, your RRSP would have traditionally been your ticket to your personal paradise.
Between the gig economy, changing work demographics, and the invention of TFSAs, more and more people seem to be wondering if an RRSP is really the bulletproof retirement plan that it used to be.
How exactly does an RRSP impact your long-term finances? Are RRSPs worth it?
Read on to learn all about RRSPs, their pros and cons, and, finally, whether or not it makes sense for you to have one.
What is an RRSP?
RRSP stands for Registered Retirement Savings Plan.
The general idea behind this account is that you pay a small portion of your income during your working years so that when you're ready to retire, you have funds that you can rely on for your day-to-day living expenses.
You can invest the balance of your RRSP for larger returns and you can compound your earnings over the course of your working career.
After 10, 20, 30, or even 40 years, on paper, you'll have a tidy sum of money sitting in your RRSP.
Depending on who you ask, this slow and steady approach to managing your money could be all you need to ensure that you're able to retire with a comfortable amount of savings.
RRSPs and Your Money: A Quick Overview of the Pros and Cons
Clearly, RRSPs seem like a nice idea in theory. Do they have any tangible benefits that don't make it sound like a super abstract concept that you won't benefit from until later?
Here are some key advantages of RRSPs that have made them the go-to retirement strategy for many financial advisors over the years.
Benefit #1: Your Savings Grow Tax-Free
From your personal income taxes to the money you spend on food and major purchases, it seems like everything you buy has a tax attached to it these days.
Any money you might make on the stock market is no different. That's why profits that come from your investment portfolio will generally be subject to what's known as capital gains tax.
However, if your savings are invested in the stock market through your RRSP, your account balance can grow without being subjected to tax on the spot. This gives you a legitimate opportunity to sit back and let your account grow without problems.
Benefit #2: RRSP Contributions are Tax Deductible
When you put aside a portion of your pay cheque and leave it in your savings account, the CRA will generally treat that as you just spending your money as you see fit.
If you put that same amount of money into your RRSP before the RRSP deadline, on the other hand, suddenly you've got a tax deduction on your hands.
If you can contribute enough to take your taxable income down a bracket or two, that can add up to a substantial return during tax season.
Benefit #3: You Get Compounding Benefits
Making a regular RRSP contribution sometimes has another money-generating advantage: You can compound your balance in ways that can't always be replicated through non-RRSP methods.
Here's an example: Many employers will match your RRSP contributions either directly or through Group RRSP plans. If your employer matches you $1 for every $1 you contribute, for example, you can effectively double your retirement balance in ways that might not have been possible with a standard savings account or a TFSA.
Similarly, it's also possible to maximize your tax deduction by reinvesting your tax return into your RRSP for even bigger returns.
These are additional ways of growing your balance and compounding your returns that you just can't do with most standard savings accounts.
Benefit #4: You Can Withdraw Funds if You Really, Really Need To
Life can come at you in unexpected ways.
Maybe you have a sudden opportunity to attend grad school or get a second degree. Maybe you have a chance to buy a home for the first time but you haven't saved enough for a down payment.
Although most people think of their RRSPs as a strictly-for-retirement kind of account, programs like the Lifelong Learning Plan and the Home Buyers Plan make it possible for you to withdraw money from your RRSP to finance your goals.
This in turn makes it possible for you to basically borrow a 0% loan from yourself that can save you a lot on interest in the long run.
The Problems with an RRSP
With all of those benefits, nobody would blame you for wondering how RRSPs became such a topic of contention in some circles. Tax-free growth? Tax deductions? If you like money, then an RRSP should be a no-brainer, right?
Well, not exactly.
Before you start scrambling to call up your bank and demand your money, here are some of the drawbacks of an RRSP account.
Problem #1: It's Still Taxable
While the growth in your RRSP is tax-sheltered and you get the benefit of an upfront tax deduction when you contribute, there's still a very big difference between a tax-deferred account and a tax-free account.
You're taxed in full when you withdraw money from your RRSP.
If you withdraw early because you need funds to tie you over or you're nearing retirement anyway, you can expect to see that reflected in your taxes.
Problem #2: Too Much Money in Your RRSP Can Be a Bad Thing
It turns out that because of the whole, fully-taxed-upon-withdrawal part of using your RRSP, having too much money in your account can put you in a higher income bracket even after you retire.
Most people picture themselves going into retirement after years of making solid money and then relying on their RRSPs in the absence of income. However, if you were self-employed and reporting your income differently or you adopted a dividend growth strategy that grew your annual income over time, there's a very real chance that you could retire to a higher income bracket than when you started.
If that happens, you run the risk of not being eligible for OAS (Old Age Security) payments when the time comes while also paying more in personal income taxes.
While this isn't necessarily a financial deal breaker for many people, these snags are why it's important to know how much retirement money you actually need.
Problem #3: RRSPs Have Limited Tax Benefits for Lower-Income People
Tax deductions like the ones we talked about earlier are great if you're making enough money for it to matter.
In Ontario, $50,000 puts you at a 9.15% personal income tax bracket. A $5,000 RRSP contribution could put you in the next lowest bracket of $45,142. This could theoretically have you paying a personal income tax of 5.05%.
You don't need us to tell you that 4.10% in tax savings could represent a significant chunk of change over the course of several years.
If you're already in the lowest tax bracket or if you're otherwise in a place where maxing out your RRSP contribution limit won't move the needle much in terms of tax deductions, the benefits of an RRSP may not be as useful to you.
As a result, TFSAs are recommended as a better option for people who are on a lower income.
So, Are RRSPs Worth It?
You might have read all of this while tapping your fingers and asking "But are RRSPs worth it?"
This might sound like an anticlimax, but honestly, it depends on the specifics of your financial situation.
That being said, there are a few general rules of thumb: If you make less than $50,000, you may benefit from a TFSA rather than an RRSP. If you expect your taxable income to go up in retirement, you're likely better off with a TFSA.
If you make more than $50,000 and you expect your tax bracket to go down when you retire, then an RRSP is definitely worth it for you. If you expect to earn more after retirement or you have reason to be concerned about having too much money in your RRSP, a TFSA can be used to bring some financial relief.
As you can see, RRSPs aren't a one-size-fits-all solution. Depending on the state of your finances, you may nonetheless find them to be a valuable part of your retirement planning strategy.
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