It’s RRSP season. You may have noticed the billboards along the roadways and banner ads when you log in to your bank account. Every year, the financial industry spends millions telling Canadians to put money into an RRSP. Many of those ads even promise cash incentives to those who do.
It’s not surprising that banks and financial advisors heavily promote RRSPs. Since the money you put in an RRSP is intended for retirement, whoever sells you an account can expect to earn investment fees from you for years and decades to come.
So entrenched is the RRSP in the Canadian psyche, that few people seem to question whether it’s actually a good idea or not. So, is it? With the benefit of having analyzed more than 100,000 financial plans made for Canadians from all walks of life, we can confidently say that the answer is “it depends.”
Here are three myths surrounding RRSPs that might help shed some light on your personal situation.
Myth #1: An RRSP is a great way to save tax
An RRSP is definitely a great way to get a tax refund. Everybody likes the feeling of coming into money, and many people have retail or vacation rituals built around spending their refund.
In case you’re not familiar with how this works, let’s say you made $60,000 last year and were in a 30% tax bracket. You’d normally pay $18,000 of income tax (30% of $60,000). However, if you put say $6,000 of your income into an RRSP, that portion would no longer be taxed. Assuming your employer was taking deductions all year, you could be in line for a $1,800 refund (30% of $6,000).
However, the story doesn’t end there. That $6,000 you put in your RRSP is going to grow. Let’s say it becomes $12,000 by retirement. Guess what? You’re going to have to pay tax on the whole amount when you withdraw it. If you’re still in a 30% tax bracket, that means a tax bill of $3,600. But worse, if you’ve been extra successful in life, you might have climbed your way to a 40% or even 50% tax bracket. What if that $1,800 refund ends up costing you $6,000?
The moral of the story is that an RRSP is a good way to get a small financial boost immediately, but it doesn’t always pay off in the long run. It’s a vehicle to postpone tax, not to truly avoid it. Depending on your current and future expected tax situation, an RRSP might not work in your best interest.
Myth #2: An RRSP should be your top financial priority
There’s an interesting glitch in human behaviour that behavioural economists call “mental accounting.” This refers to the tendency to mentally divide our money into separate buckets and to think about each bucket in isolation, not as a whole.
For example, imagine someone who’s working on two financial goals at the same time: building up their investments and paying down their credit cards. Some months they succeed in hitting their investment target, and other months they don’t. Some months they make a nice big payment on their cards, and other months they end up with a higher balance.
What they aren’t seeing is the relationship between those two projects. For example, if they expected to earn 6% per year from their investments, and their credit cards were charging 19% per year, they should put every available dollar towards paying down the credit cards. It doesn’t make sense to make 6% with one hand and pay 19% with the other. When you break down those mental accounting buckets, you realize that “making money” and “saving money” are two sides of the same coin.
So even if an RRSP makes perfect sense for your tax situation, it may not be the thing to focus on right now. Are all your high-cost debts paid off? Do you have an emergency fund set aside? Do you have insurance to protect your income and, if you’re a parent, cover your children? If you answered “no” to any of those questions, you may have financial priorities that should rank above your RRSP.
Myth #3: An RRSP loan is a great way to catch up
Banks want you to contribute to your RRSP, and if you don’t have the money available in your bank account, they might offer to lend it to you. This is almost always a bad idea.
The simplest way to look at it is this: if you have the money to make a series of loan payments, then you should just use that money to make RRSP contributions instead. Why take out a loan with interest, just to put the loan proceeds in your own RRSP?
The only possible incentive is to try to maximize your current tax refund. But this approach can set you up for a vicious cycle. Think about it: take out the loan, make payments all year, then when the RRSP deadline comes around again next year, what will you do? Take out another loan? And what about the year after that? Sooner or later, whatever gain you got from that first tax refund will be frittered away on loan interest with no end in sight.
If an RRSP is right for you in terms of your taxes and your financial planning priorities, then the best answer is almost always to set up automatic monthly contributions that you can afford to fund using your regular income, and just say no to any type of loan scheme.
So there you have it. The RRSP is a Canadian institution and a very useful financial tool in many situations. But there are some nuances and the last thing you’d want to do is charge ahead blindly. Our advice is to build a solid financial plan to guide your decisions and help you make the most of your options.