Dear Mike: I've never been a big fan of RRSPs, but you seem to like them. Tell me why it's still a good idea to put my money into them.
Dan in Saanich
I've been advising clients for more than 15 years, through all kinds of markets, and it still surprises me when someone says: "I don't like RRSPs." I invariably ask why? And the answer is always some variation of the following two responses: "Well, you have to pay all that tax when you take your money out." Or, "All they do is lose money."
Now when I ask most Canadians if they like having their pension, the response is pretty universal: "Yes, but I wish it was more." When I ask them why they like their pension, I'm often greeted with a look as though I've grown a second head. "Because it gives me an income I can live off in retirement".
Having a pension is a huge benefit going into retirement, but the main advantage of a pension plan is the forced savings aspect. When you work for a company that provides a defined benefit pension and you enroll in the plan, the contribution is taken from your paycheque pre-tax, every pay period whether you want to or not. That money is invested into the pension pool whether the market is up or down, or, if you could afford it, that month or not. There is no secret as to what a pension holds either. If you look at any of the major pension plans in Canada, you will see a lot of the same types of investments you can hold in your RRSP: A well diversified mix of stocks, bonds, and cash. The difference is that pension fund managers tend to invest consistently and systematically through all markets, which is why they tend to out-perform the average RRSP investor.
With regard to the tax aspect, let's examine a pension versus an RRSP over the lifetime of the annuitant.
With a pension, you contribute money to the plan on a pre-tax basis that is reflected on your Tax Assessment as a Pension Adjustment.
With an RRSP you generally contribute the money to the account on a post-tax basis, receiving a tax slip that reduces your taxable income for the year by that amount.
Over your working life, both of these assets are exposed to the market, and grow in value through a combination of ongoing contributions, interest, dividends, and capital gains. Once you retire, you may use these programs to fund your retirement. In the case of the pension, that income is taxed as it is paid out to you. The underlying assets that the pension derives its value from, remains sheltered and untaxed within the plan. The same is true of the RRSP account. Any funds drawn from the account are taxable, but the value of the account still held within the plan remains sheltered from taxation.
When the annuitant dies, there are options for both plans. With a defined benefit pension plan, you elect your beneficiary options when you retire. These options generally range from 100 per cent single life, to as much as 100 per cent benefit for your spouse once you die. Inevitably, the greater the death benefit for the surviving spouse, the lower the monthly pension benefit for the annuitant. The conversion of the pension benefit from deceased annuitant to surviving spouse is a tax neutral event. Compare this with the RRSP account. If you name your spouse as beneficiary, 100 per cent of the value of the account transfers to your spouse regardless of their accumulated RRSP contribution room. It is also a tax neutral event.
It's on the death of the spouse where most people get concerned with RRSPs.
When the spouse dies, the remaining value in the RRSP account is liquidated and becomes income for the spouse in their final tax return. This generally means a lot of tax must be paid out of this amount. But let's compare that to the defined benefit pension plan. When the surviving spouse dies, whatever remains of the underlying value of the plan is gone. Back into the pension pool. Sure, you don't have to pay any taxes, but that's because the estate doesn't actually get anything.
Pensions are a great benefit, but RRSPs are a necessary answer for those that don't have a job that provides a pension for them. The key to maximizing the benefit of your RRSPs is to treat them like a pension. Ask your financial adviser to calculate how much you need to contribute to create a pool of money that will give you the income you need in retirement. Now make sure you contribute that amount to your RRSPs every pay period without fail, through good markets and bad, strong times and lean.
Mike Watkins, CFP, FMA, FCSI, CSWP
Watkins is a financial adviser with Edward Jones and author of the financial planning guide It's Only Money. To ask a question call 250-418-0114.
