Since the deadline to contribute to your RRSPs for the 2016 tax year is fast approaching (the deadline is March 1 FYI), I wanted to explore some longstanding misconceptions about RRSPs (Registered Retirement Savings Plans) that you may not know about. And if you do, this is still a good refresher (and maybe something you’ll want to share with some of your less-informed friends).
One of the great things about doing what I do is I get to find out what other people think (or believe) about money. And the sad truth is there is a lot of false information floating around.
So, I wanted to set the record straight and debunk 5 misconceptions about RRSPs that I want everyone to know about.
1. RRSPs Are Not Investments
That’s right, RRSPs are not investments — they are vehicles in which to hold investments.
I can’t tell you how many conversations I’ve had with people that tell me “Oh yeah, I’m invested in RRSPs.” Well, that’s not a thing, so no…you’re not.
An RRSP is simply a type of account. You can put almost anything in there including cash, GICs, stocks, mutual funds, index funds and exchange-traded funds.
Obviously since it’s meant for your retirement savings, it’s not recommended to just hold a bunch of cash in there since it won’t grow into much of much when you’re ready to make a withdrawal in retirement. Still, it’s important to know that you don’t have to put investments in your RRSP if you don’t want to.
So why use an RRSP to house your investments instead of just a regular investment account? The tax benefits. Check out #5 below for more info about the benefits of RRSPs.
2. You’re Not Limited to Just One RRSP Account
Although you do have a limit on how much money you can contribute to your RRSP each year, that doesn’t mean you are limited to having only one account.
For instance, it’s quite normal to have one RRSP that you started yourself, then another RRSP through your employer who offers an RRSP matching program.
That was my set-up before going self-employed. I had an RRSP I set up myself through a financial institution, then another RRSP through my employer who matched my contributions after 2 years. And it’s a good thing I stayed the 2 years because I walked away with an extra $2,500 in my pocket thanks to their RRSP matching program.
So, is it a good idea to have multiple RRSP accounts then? Not really.
Personally, I’d say stick with two at the most, otherwise it just gets convoluted. And if you’re thinking that having 3-5 RRSP accounts invested in different things is a good way to diversify your investments, that’s not a great strategy. You can invest in multiple types of investments within one RRSP account.
If you need more convincing, check out this great article by The Globe and Mail.
3. You Will Have to Pay Tax on the Money in Your RRSP (Eventually)
Contributing to an RRSP doesn’t mean you don’t pay tax ever. It just means you’ll pay it later. When will you pay that pesky tax you wonder? When you withdraw your money.
Let’s say you don’t want to withdraw any of your money until you absolutely have to. That would be the day before you turn 72. This is the age when you must deregister your RRSP.
Now, most people don’t withdraw all of their money at once when they deregister their RRSP. Let’s face it, that’s a lot of tax to pay in one fell swoop.
As for other options, you can purchase a single-payment life annuity, a fixed term annuity, set up a Registered Retirement Income Fund (RRIF), set up a Life Income Fund (LIF), and lastly you can set up a segregated fund.
No matter what route you decide to go, with all of these, you will have to pay taxes on the money held in your RRSP one way or another.
4. You Do Have to Repay Money You Take Out for the Home Buyer’s Plan
With home prices at record highs, many Canadians are opting to take money out of their RRSPs to help them with their down-payment. This is called the Home Buyers’ Plan (eligible to first-time home buyers).
When my husband and I bought our townhouse this summer, we discussed whether we wanted to take advantage of the Home Buyers’ Plan. We inevitably decided against it and vowed not touch a dime in our RRSPs until we were retired. We had enough money for our down-payment, so why risk losing out on future gains from the investments in our RRSPs?
That being said, if you do want to withdraw money from your RRSP for a down-payment, just remember that it’s not a free pass or anything like that. You can withdraw up to $25,000 from your RRSP, but you have to pay it back. And if you don’t, it’ll be treated like income on which you will have to pay tax (which sort of defeats the purpose of using the Home Buyer’s Plan in the first place).
Think of it more like an interest-free loan that you have 15 years to pay off. And don’t think you can just pay it all off in year 15. You need to make annual payments until every last dollar you took out is back where it came from.
When I just started learning about personal finance and investing in my early 20s, I thought opening up an RRSP was the smart thing to do. I wanted to start saving for my retirement and take advantage of compound interest on my investments as soon as I could. And this probably was the smart thing to do, because TFSAs (Tax-Free Savings Accounts) didn’t exist until 2009.
That being said, now that I’m much more informed about the benefits of RRSPs and TFSAs, I do have to say that RRSPs may not be the best choice for young investors.
You see, there are two main benefits of contributing to an RRSP.
The first benefit is being able to defer paying taxes on the money you make on your investments to a later date.
The second is the tax credit. That’s why so many people scramble to contribute to their RRSP before the March 1 deadline. By doing so, they can reduce the amount of income tax they have to pay for the year because they can claim their RRSP contributions as a tax deduction.
In simple terms, you can use your RRSP contributions for the year to get into a lower tax bracket, thus lowering the percentage of income tax you have to pay.
For instance, if your taxable income is below $45,916 for 2016, you’ll only have to pay 15% in taxes. But if you make over $202,800, you’ll be taxed 33%. That’s more than double! Which is why you may want to wait to until you’re in a higher tax bracket to take advantage of the RRSP tax break.
Instead, it’s recommended to invest in a TFSA when you’re in a lower tax bracket. Also, with a TFSA you’re not deferring pay taxes on the investment income you generate, it’s actually tax-free.
What other misconceptions about RRSPs do you know of? Let me know in the comments!