The Registered Retirement Savings Plan (RRSP) is also one of our favourite accounts to build long-term wealth with, and the same should apply to you. On that note, it’s also an account that can trigger huge opportunity costs if not used wisely. For today’s post, we’ll share how you can avoid these 5 big RRSP mistakes – in your asset accumulation and asset decumulation years.
At the end of this post, we’ll also share how you can avoid 5 big TFSA mistakes. This makes using the RRSP and TFSA effectively and efficiently essential for your retirement income needs.
Mistake #1 – Not reinvesting the RRSP-generated refund
We’re aware that many readers of this site are likely familiar with the RRSP benefits, but we’ll list them below anyhow:
- RRSPs are highly effective for Canadians who will be in a lower tax bracket in retirement versus their contribution years.
- RRSP contributions provide a tax deduction, allowing for,
- Long-term tax-deferred growth.
Related to #3, investing wisely inside your RRSP offers great tax-deferred benefits when you invest your contributions in investments with higher returns than cash or bonds.
Case in point: you can retire using just your RRSP!
Of course, we at Cashflows & Portfolios don’t recommend owning just equities although we have a bias to owning that asset class ourselves in our RRSP accounts. We are simply asking you to reflect on your investment goals, time horizon and risk appetite to decide on an appropriate asset allocation that meets your needs.
Regardless of your asset allocation inside this account, one of the biggest mistakes you can inflict on yourself is spending any RRSP-generated tax refund/tax deduction. The RRSP-generated tax refund is great but it’s actually temporary; a government loan. You need to give some money back at some point.
“This makes reinvesting the RRSP refund year after year absolutely critical to optimize wealth building – to take major advantage of an essentially long-term but not permanent government loan.”
Contributing to the RRSP makes the most sense when your marginal tax rate at the time of contribution is greater than your marginal tax rate at the time of withdrawal. If this tax situation applies to you, for any “RRSP season” then by all means use the RRSP as much as you can to defer tax now, grow your portfolio over time, assuming you get your RRSP-generated refund back only to reinvest money back into your RRSP to further compounding.
Simply put, RRSPs are an amazing tax deferral tool but they are not the only way to build wealth. That can really depend on your income level and why you should consider prioritizing your TFSA over your RRSP in some cases.
Mistake #2 – Investing inside the RRSP when the TFSA makes more sense
You can see above a significant oversight some Canadians make: if you spend any RRSP-generated tax refund and you do not reinvest that money back into your RRSP, you are missing out on the tax-deferred government loan provided to you for wealth-building power.
We’ll let The Wealthy Barber David Chilton be blunter than us:
“If you’re going to put money in a registered retirement savings plan and “blow the refund on something stupid,” then a major advantage of the RRSP – the immediate tax benefit – is lost, he says.”
That said, maybe you shouldn’t invest in the RRSP at all – especially if you are already in a lower income.
Remember, RRSPs are highly effective for Canadians who will be in a lower tax bracket in retirement versus their contribution years. Lower-income Canadians don’t have as much money to likely invest – inside their RRSPs or elsewhere. This is why it has always made sense to us to maximize contributions to your TFSA, first, regardless of your income level, and then maximize contributions to your RRSP thereafter as your income grows over time for tax-deferred growth.
Even if you totally ignore the RRSP as an investing account, using just your TFSA for investing, wisely, will still mean your money has the potential to make more money over time (lots of it) via dividends, capital gains or a combination of both depending on what you own.
To see the real power behind the TFSA as an investment account, check out one of our more popular posts below. You can actually retire using only your TFSA!!
Mistake #3 – Not taking advantage of income splitting
This is a common RRSP mistake made by couples in their asset accumulation years and drawdown years: while contributing to a spousal RRSP is a great way to reduce taxes, now, we believe few Canadians understand the merits of income splitting as part of their future tax planning benefits.
For example, Debbie, the higher income spouse, has an RRSP contribution room of $25,000 this year can choose to contribute $10,000 to her own RRSP and the balance to the spousal RRSP of her partner, Shane.
In doing so, Debbie will get the tax refund on the entire contribution of $25,000 at her higher marginal rate. At retirement, this couple will withdraw from their individual RRSPs, with Shane at a lower income rate, resulting in lower tax paid compared to if the entire contribution was only made to Debbie’s RRSP.
One of the most common mistakes that Canadians make, when it comes to the spousal RRSP, is some believe the contributor’s name is registered as part of the plan – not true. The spousal RRSP is registered under the name of the spouse making the lower-income and the plan is theirs, all along (Shane above in our example.) This is the person who makes the investment decisions and is the only one allowed to withdraw money but can do strategically when their income is lowest – in the form of income splitting for maximum tax benefits.
Are there some spousal RRSP rules you should know?
While on this subject, we want you to know there is a 3-year attribution rule, which means contributions to a spousal RRSP can’t be taken out for at least three years after the date they were put in. If the funds are taken out within 3 years, the money becomes taxable income for the contributing spouse. Ouch!
A reminder for higher-income earners that your RRSP contribution limit is the same whether you have two accounts (or more?) or just one. For example, if your contribution limit is $25,000 like Debbie, you can divide that amount between your RRSP and the spousal RRSP (Shane). Just don’t go over the total contribution limit.
Like a regular RRSP, you can keep adding to a spousal plan until the end of the year your spouse turns 71. RRSPs can convert into retirement income products, such as registered retirement income funds (RRIFs) or annuities, at the end of the year you turn 71. At this point, the retirement income is taxed in the lower-earning spouse’s name at his/her current tax bracket.
Like everything with our tax system, it’s overly complex.
But knowing what is/is not eligible for pension income splitting can be huge.
Income splitting depends on both the age of the pensioner and the type of pension received. For example, in general terms:
- Pension payments from programs such as CPP (Canada Pension Plan) and OAS (Old Age Security) are not eligible for pension splitting regardless of age.
- If you are the recipient of the pension and are 65 or older, you may split income from your RRSP turned into a RRIF, life annuity, and other qualifying payments.
- If you are under 65, only certain life annuity payments and amounts received from the death of a spouse (such as RRSP and RRIF) are eligible for pension splitting.
- Lump-sum pension payments and other non-registered pension plans are not eligible for pension splitting.
When you report eligible pension income, you may be entitled to an additional credit called Pension Income Amount of up to $2,000 per person. How? At age 65, you can convert some of the funds in your RRSP to a RRIF, then make withdrawals from the RRIF, which qualify for the credit. Now, the federal pension income tax credit is not the best reason to convert your RRSP early…but early conversion can have other tax benefits, especially when the balance of your RRSP is larage.
Knowing income splitting rules can be an enabler to understanding how to lower your taxable income not just for one year, but over many years. Read on!
Mistake #4 – Always waiting until age 71 to convert your RRSP
One of the common misconceptions about owning an RRSP is that you can’t withdraw from this account until retirement or you must wait until the end of the year at age 71 to convert your RRSP to an RRIF.
Just. Not. So.
Unlike the TFSA, RRSP withdrawals always have a tax impact – which is likely why many people don’t think about withdrawing from their RRSP until they are forced to – only to complain about the tax impact when they do…
This makes the retirement drawdown order critical to understand in retirement since ideally, you want to withdraw RRSP funds when you may be at a lower/in the lowest tax bracket; the amount withdrawn is always added to your taxable income for that year and taxed.
What we find with savvy clients at Cashflows & Portfolios is they usually attempt to withdraw from their RRSP, before they are forced to convert it to an RRIF in the year they turn age 71.
Always waiting to convert your RRSP to an RRIF, without making any RRSP withdrawals prior (or turning your RRSP into an RRIF voluntarily), usually translates to one or more of the following problems for retirees in their 70s:
- Their taxes go up, in their 70s, when they least expected it or wanted it thanks to forced RRIF withdrawals when combined with other income sources (e.g., CPP).
- They didn’t realize they could spend more money prior to the year they turned age 71.
- They didn’t realize they could lower their taxes, and also take advantage of incentives like the pension income splitting tax credit – see above. Pension splitting allows you to allocate up to 50% of your eligible pension income with your spouse or common-law partner for income tax purposes.
Making some or most of your RRSP withdrawals before the year you turn age 71 is not the end of the world, in fact, it’s usually beneficial. Just know when you do so, the withholding taxes are not the final tax impact. When you file your tax return, the withdrawal is added to your tax filing information and THEN the actual tax liability for the year is determined. So, depending on your income from other sources, if your marginal tax rate is higher than the withholding tax, you’ll be on the hook for more taxes. Otherwise, you’ll get a refund for the excess tax withheld.
Lastly, just be mindful if/when you do make RRSP withdrawals before converting it to an RRIF, you’re really ready to do so:
Mistake #5 – Thinking the RRSP is an estate tool
The final, and VERY big mistake we want Canadians to avoid as part of our 5 big RRSP mistakes is when it comes to using the RRSP or RRIF as an estate planning tool. We think this can be costly.
For one, many people name an adult child as their RRSP beneficiary when they still have a living spouse or common-law partner. The challenge with this is that RRSP assets transfer tax-free to [the RRSP of] a spouse at death. But payments made to [adult, non-dependent] children and others beyond a qualified spouse are taxable as income.
Another challenge: if you have no living spouse or partner to leave your RRSP to your estate? The CRA will add the fair market value of the assets held in your RRSP to your income in the year of your death. Keeping your RRSP around for an extended period can trigger a significant tax bill for your estate that could diminish its value for your heirs.
RRSP (and RRIF) beneficiaries is a complex and personal subject to tackle, and My Own Advisor has this covered below, something we’ll tackle in time on our site in response to our client needs.
Further Reading: Beneficiaries for TFSAs, RRSPs, RRIFs and other key accounts.
At Cashflows & Portfolios, we see time and time again, the way to optimize the use of the RRSP is as follows:
- Contribute money when your income is highest.
- Take advantage of long-term tax-deferred growth.
- Take out money when your income is lowest and whittle it down over time.
Our best advice to you: use your RRSP as a tool for your retirement income and not for any estate planning.
Avoid these 5 big RRSP mistakes summary
The Registered Retirement Savings Plan (RRSP) is a great way to build long-term wealth for retirement but it’s not the be-all, end-all.
Unlike the TFSA (that is an excellent investing account for every adult Canadian to use), we believe the use of the RRSP can be distilled down to these core needs:
- RRSPs are highly effective for Canadians who will be in a lower tax bracket in retirement versus their contribution years and are therefore very effective for modest to higher-income earners.
- RRSP contributions provide a tax deduction today, allowing for long-term tax deferred growth.
- RRSP assets are best with a bias to equities vs. cash or bonds given your accumulated RRSP potential value is not all yours to keep, some of that asset value is actually a government loan you must pay back. Make good use of the compounding time you have!
Every adult Canadian should take advantage of the TFSA.
Many Canadians should take advantage of the RRSP depending on their retirement investment needs.
Improve your retirement readiness at a low cost!
Everyone has a different path on their asset accumulation journey. We know. At Cashflows & Portfolios, even though we both own 7-figure investment portfolios now, we’ve built our respective portfolios similarly but differently.
The common denominator on our retirement readiness path is we have and intend to avoid these RRSP mistakes. We can help you out too!
Whether that’s understanding how best to keep the TFSA “until the end” in asset decumulation, spend your RRSP sooner than later, knowing how RRSP drawdowns relate to a workplace pension, government benefits, LIRA/LIFs, corporations, and more, we can help.
We answer client questions such as:
- What registered accounts do I draw down first?
- How much income will my investments generate?
- Do I have any idea how long this income might last?
- What amount of taxes will my portfolio incur?
- When should I take my workplace pension?
- Is it more beneficial to draw down any non-registered money before RRSPs before TFSAs?
- And much, much more…
If you are interested in obtaining private retirement projections for your financial scenario, please contact us here to get started.
Stay tuned for more, great, FREE content on our site. We’re happy to help.
Mark and Joe.
Further Reading and Posts:
- You’ve learned about some BIG RRSP mistakes. Read on:
- These are the RRSP contribution limits for this year, including Everything You Need to Know about the RRSP in this post.
- Here are some of the top tax tips for any retiree to consider.
- As a prospective retiree, why you should take CPP at age 70 and not sooner.
- Read on to put an end to the RRSP vs. TFSA debate subject here.
- We covered Everything You Need to Know about the TFSA in this post.