RRSP Tips and Traps – part 2

Here is a continuation of my RRSP Tips and Traps blog.  Part 1 dealt with the tax savings and deductions of RRSPs.  Part 2 is a potpourri of other RRSP Tips and Traps.

Savings for Retirement!?

In Part 1 of my RRSP blog, we discussed the tax savings elements of RRSPs.  However a main reason RRSPs were created was to give us a mechanism to save for retirement, especially those of us we are not associated with any other retirement savings plans outside of government sponsored plans.  We are taking some of our net worth and deciding not to spend or have fun with it today, but save it so that we can spend or have fun with it later!

A recent CBC article suggests that Canadians are only saving 4% of their disposable income in RRSPs and TFSAs (http://www.cbc.ca/news/business/taxseason/story/2013/01/02/f-rrsp-2013-by-the-numbers.html).  As part of your retirement plan, you should consult with an advisor to assess what annual goals you should set towards reaching your retirement goals and needs.

Monthly Contributions vs. Annual Contributions

The equity and fixed income markets have generally been a happy place over the past several months, but we have experienced quite a bit of turmoil over the past several years to make many of us doubters for investing in this space, or fearful of buying at the wrong time.  One way to reduce this potential volatility of investing in these markets is to contribute monthly towards your annual RRSP goals.

Contributing monthly means that over the course of a 12 month period, you have made 12 purchases.  By definition, that is an average purchase price you have paid for your bundle of stocks, bonds and other investments.  As it is an average, it will not be the highest price paid over the 12 month period, nor will it be the lowest price for that same period.  It will be something in between those two book-ends.  This is often referred to as “dollar-cost averaging”, and  has two clear benefits:  1) it is a way to make your RRSP annual contributions easier to accomplish by breaking it up into smaller monthly contribution goals; and 2) it helps mitigate the risk of investing at an inopportune time by paying an average price for your investments versus an annual contribution strategy.

I strongly recommend monthly contributions for all of my clients.

RRSP vs. Mortgage Repayment

There are several good RRSP versus Mortgage repayment calculators available on Canadian bank and life insurance companies.  I have one linked under my Planning Tools of my website if you are interested.  The big picture is – do you have too much debt?  If you do, pay off your debt first!

What is too much debt?  To me, it is when more than 33% of your disposable income is going towards debt interest and principal payments every month.  It is also when your debt (mortgages, line of credits, credit cards, etc) represents more than 60% of your Total Assets.  I call these two scenarios “highly leveraged”.  Highly leveraged people are generally more susceptible to risk if something happens to them for illness, job loss or other unplanned event (major house repair required).  The best way to pre-plan for highly leveraged people is to ensure that they have adequate insurance coverage for “what-if” situations, and to strategically targeted early repayment of your debts.

Many people will prefer to do an RRSP contribution, and use the tax refund to repay debts.  This way, they tackle both goals.  Generally I like this strategy, but in some cases I would prefer a direct target to debt repayment in lieu of any RRSP contributions when that person is highly leveraged.

RRSP vs. TFSA

Again, there are several calculators available for comparing an RRSP versus a Tax Free Savings Account (“TFSA”).   My general comments on the topic are as follows:  I currently prefer using an RRSP for retirement savings and a TFSA for a source of emergency funds.

What do I mean for emergency funds?  Every healthy personal financial plan has an asset that is preserved for emergency purposes.  Emergencies are those things that we do not plan to happen, but if they do they impact our cash flow and our financial and retirement plans.  Emergencies I’m referring to include a long-term illness, an injury, loss of job, or an unforeseen repair needed for the house, as examples.

Financial planners will recommend you maintain 3-6 months of your monthly disposable cash flow needs in an emergency fund.  The emergency fund should be invested in a conservative and liquid investment, as you never know when you may need to access it.  As a consequence many people will invest their emergency fund in interest-producing investments (e.g. GICs, bank deposits, shorter-term bond or fixed income funds).

A TFSA, in my opinion, is currently a good place for an emergency fund because:  1) any interest income is not subject to taxation, 2) TFSAs can be withdrawn without any tax consequences, and 3) you can re-contribute to a TFSA for any contribution you made in the past and then withdrew for emergency purposes.

For more information on TFSAs, check out the Canada Revenue Agency website at:  http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/tfsa-celi/menu-eng.html.

Home Buyers and Lifelong Learning Plans

RRSPs have two programs that allow you to withdraw from the RRSP without immediate tax consequences: 1) Home Buyers Plan; and  2) Lifelong Learning Plan.  I won’t go into further details in this blog, instead you can refer to the Canada Revenue Agency link below for further information on both programs.

Home Buyers Plan – http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/rrsp-reer/hbp-rap/menu-eng.html

Lifelong Learning Plan – http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/rrsp-reer/llp-reep/menu-eng.html

My only comment here is this – if you are interested in using either of these programs from your RRSP, then please ensure that your investments in your RRSP are appropriate.   You shouldn’t, for example, invest in long-term higher-risk investments requiring 10 year investment horizons when you plan to utilize these plans in the next 2-5 years.  Your advisor needs to be aware of your intention towards using these  plans, and then needs to build an investment strategy that is appropriate.

If you have any questions, send me a message at marco@mgfadvisory.ca.