We spend our teenage years proving we are not our parents, and then our adult years confirming that we’re not too different. But when it comes to retirement, today’s workers are in a very different situation from those of yesteryear. Our parents grew up in a different era; one of thriving economies, careers that consisted of 35 years with the same company and the holy grail of pensions—the defined benefit pension plan. It was a time of confidence in our ability to pay for retirement. You’d worked for the Company for 35 years, of course you would be due a pension. And yes, it would keep you in the life you had become accustomed to.
Well, that was then, and this is now. We are now responsible for our own savings and for our own future. “Spend now, worry later” is a scary concept.
Here are six nuggets of advice to make you wise about RRSP contributions now, so you build that nest egg for later.
RRSPs allow the saving of before-tax dollars and the deferral of the tax on the investment until retirement, when in theory, the investor would be in the lower tax bracket. The result: saving real dollars. In other words, saving for later is also saving money now.
Indeed, saving for tomorrow is a less-than-common concept in today’s society. We may save for emergency funds, or for a kitchen renovation. But, putting money aside for 30 or 40 years seems foreign and abstract, to say the least. However, that $1,000 a month you are putting aside now for the kitchen renovation would result in just over two million dollars over 40 years. Thanks to the magic of compound interest, it can build quickly, but only if it’s saved in the first place. If the resulting tax refund (or even part of it) from each year’s RRSP contribution is also invested, the savings will grow even more, and faster.
The beauty of compound interest on RRSP investments is making it work for the investor, as opposed to interest on a credit card when it works by compounding ferociously against the holder. However, it can only work if there are savings there to begin. See the trend? There needs to be a conscious effort to treat the build of an RRSP as you would any other payment. It’s best when withdrawn automatically from the chequing account. First mortgage, then RRSP. Maybe even in the reverse order!
RRSP room can only be created through earned income. It’s simple for the T4’Ed employee: 18% of earned income, up to a maximum of $22,450. However, for the owner-manager, tax planning really comes into play. While they can invest directly in the Corporation using before-tax dollars, remember that the income is taxable whether it’s capital or interest in nature. Only the RRSP vehicle allows true deferral of taxes. Therefore, take the time to consider investing outside of the Corporation using true before-tax dollars. Consulting with a financial planner or accountant can help the owner-manager truly leverage the advantages.
Income splitting is a concept that is available to seniors. Most types of pension income can be split to ensure that both partners are in the same bracket. Spousal RRSP contributions are another way of leveling the playing field. If the contributor is already over 71 and can no longer contribute they can continue to contribute to their partner’s RRSP to continue to build their fund until the partner turns 71. This can only be done to the extent the contributor has room, but it’s an option that can save thousands.
Let’s say the contributor is in the top tax bracket of 46%. That means that for the $22,450 invested they would receive a refund of $10,327 in the year contributed. However, when that RRSP is withdrawn, it’s withdrawn in the 35% rate, therefore saving $2,245 a year. And if one spouse has little-to-no income, it would be significantly more, thanks to income splitting and the beauty of tax-deferred savings.
So, the bottom line is to start making RRSPs work for you by contributing today. Unlike our parents, very few of us have companies looking after our future with plum pensions. Get in your RRSP contribution before the March 1 deadline to offset 2011 income; and if you haven’t already, start your monthly contributions for 2012.
If your situation is more complex, such as that of a business owner with a corporation, contact a qualified chartered accountant to help you navigate the tax deferral waters. Any service fees will be more than paid for in savings, not to mention the security and peace of mind of the stable financial blocks you’re building for your future.
This article was originally published in The Financial Post on January 5, 2012.