Tuesday, January 15, 2013

Retirement Rationalizations: 6 Misconceptions About RRSPs

The statistics are clear: most Canadians are not preparing for retirement. According to a new poll by CIBC, more than half of Canadians surveyed said they did not feel adequately prepared for this later stage of their lives. When we at GoldenGirlFinance.com published an article about the importance of investing in Registered Retirement Savings Plans (RRSPs), we were flooded with comments from readers on why they felt RRSPs didn’t work; some even suggested they were a government scam!

It seems that people have a lot of reasons for not investing in an RRSP, which might account for why only about one-third of Canadians make an RRSP contribution each year. The problem is, many common opinions about RRSPs are myths that just don’t stand up to reason. Let’s look at the facts behind the flak...
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1) Taxes, taxes and more taxes

One of the most common objections to RRSPs is that they are taxed. Well yes, but so is pretty much every cent you earn. But the way RRSPs are taxed is a little bit different - and that’s what makes them beneficial for the vast majority of people.

You see, RRSPs are tax-deferred. So let’s say you make $50,000 per year in 2011 and deposit $3,000 into your RRSP. At $50,000 per year, a taxpayer in Ontario will owe about $8,900 in taxes. However, thanks to contributing to your RRSP, that amount will be reduced to about $7,800 or a savings of $1,084 (which often means you’ll get that money back in the form of a tax return). Think of it this way: the tax you paid is essentially being returned to you for contributing to your RRSP. Better still, that $3,000 contribution won’t be taxed until you withdraw it many years later as income for retirement, giving it more power to grow into a bigger lump sum.

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The real sweet deal: you are only taxed on this contribution once – when you take it out (and when you’ll likely be in a much lower tax bracket, meaning you get to keep more).
BONUS TIP: Reinvest that tax return. It’s like turbo-charging all of the above benefits!

2) Your tax rate
As previously mentioned, the general argument in favour of contributing to RRSPs and deferring paying tax on those funds is that many people will be in a lower tax bracket when they retire than they were during their working years. After all, if you are making $50,000 per year now, and you expect to retire at age 65, you will need to have more than $1 million dollars in your retirement fund to pay out that amount until you’re 90. For most people, that’s unlikely. This is why experts suggest your income will be lower during retirement. Of course, pensions and other retirement benefits count as part of your total income, so check with your tax professional to determine whether an RRSP is the best option for you.

3) The missing tax
When it comes to taxes, there’s one big thing that many of those who complain about the income tax on RRSPs are missing: RRSPs offer tax free growth on your investments. This benefit should not be ignored as an investor has the opportunity to avoid paying capital gains tax, and literally earn tax-free income within the plan for life. Therefore, regardless if you sell a winning stock, bank some interest on a GIC or earn a healthy dividend on your stocks, at the end of the year, you pay no tax.

So let’s say you have $5,000 that you want to invest. If you choose to leave it outside of an RRSP, you will first have to pay income tax. Then, if you realize a profit or earn income on that investment, you will be taxed on that as well – and that tax will be owed each and every year you crystallize a profit, earn a dividend or are paid interest thereafter. In other words, tax can absolutely cut into the overall returns on your investment. But with an RRSP, you get to skip that tax altogether, allowing the funds to grow undisturbed and tax free as long as they remain within the plan. You will only pay tax on money when you withdraw it, leaving the remaining funds in the RRSP to continue to grow tax free. Holding on to more of your cash? That’s a huge benefit not to be dismissed.
[More: Why you should contribute to your RRSP this year]

4) The markets

Another common complaint against RRSPs is how poorly they’re doing right now. It’s certainly true that the financial markets have not been kind to investors in recent years. The problem is, saying you’re not going to invest in RRSPs because the markets are poor is like saying you’re buying a new car because your current one has a flat tire. This is because an RRSP is a type of account, not a type of investment. What this means is you can put just about anything in it!

The reality is that stocks have disappointed investors many times in history. If the ebb and flow of the markets also makes your stomach ebb and flow, you can always invest in something more secure, such as a GIC.
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5) RRSPs are your money

RRSPs are often confused with pensions and other types of retirement benefits, which, in the most dramatic cases, have been misspent or mismanaged, leaving retirees with little more than spare change. RRSPs are different in that they are your own money, just like the cash you deposit into your checking or savings account. It’s basically a savings account that you can use to invest in whatever you want, and which most importantly, allows you to defer the taxes until you retire. That’s a good deal!

6) No RRSP= No retirement savings?!

Possibly the biggest problem with RRSP bashing is that it often results in no retirement savings at all. Since Tax-Free Savings Accounts (TFSAs) were introduced in 2009, there’s been a lot of debate about whether they are a better option for some individuals. This is an issue that people should discuss with a qualified financial professional. However, many of the richest people in the world go to great lengths to reduce their tax liabilities for the simple reason that it has a huge effect on net worth. So whether you opt for a TFSA or an RRSP, it’s likely that a tax-advantaged savings vehicle can help you reach your financial goals. It’s really rather simple: why would you pay more tax than you have to?

So, will you contribute this year?

RRSPs are not for everyone, but for many people they provide a great option for retirement savings. Before you decide to skip out on this investment, take the time to get to know the facts about how they work. Whether you put your money into an RRSP, a TFSA or some other type of investment, don’t let misinformation keep you from getting the most out of your money.

GoldenGirlFinance.com is a free personal finance and education site for women.

Nothing contained herein is intended to provide personalized financial, legal or tax advice. Before implementing any financial strategy, you should obtain information and advice from your financial, legal and/or tax advisers who are fully aware of your individual circumstances.

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