Canadian Capitalist

26 responses so far ↓

• 1 0xCC // Feb 20, 2008 at 9:32 am

  Another situation (which I have a series of posts in the draft stage describing in more detail) is if your RRSP account is already too big and will end up providing more than your living expenses in retirement. Once you turn 71 you are forced to convert your RRSP into a RIF (or cash the RRSP out completely which probably isn’t the best choice for most people). Every year you are forced to withdraw a set percentage from your RIF whether you need the income or not (and it is taxed as income).

  So if your RRSP (and subsequently your RIF) is too big you could end up paying taxes in retirement when you could have just had the money in a non-registered account and you have the freedom to decide when to cash out any amount you want whenever it makes sense to you.

• 2 Phil S // Feb 20, 2008 at 10:11 am

  An RSP is the easiest investment vehicle to get immediate tax relief or tax deferral when looking at retirement savings. Other possible tax advantaged investment vehicles include the use of trust funds (such as for your kids education), or setting up holding companies to hold your assets (and also isolate you from liability, for example, if you own rental property). But for setting up trusts and corporations, it is better to get lawyers and accountants involved to get it done properly, which costs money.

• 3 ThickenMyWallet // Feb 20, 2008 at 11:18 am

  If you are an entrepreneur, you have access to individual pension plans and retirement compensation arrangements.

• 4 brad // Feb 20, 2008 at 11:33 am

  I’m not 100% sure about the credit card thing: I think it could depend on your age. If, for example, you are in your early 20s and have a lot of credit card debt, wouldn’t it make sense to contribute to your RRSP because you have so many years ahead of you for that money to grow? If it takes you five years to pay off your credit card debt and you don’t contribute to RRSP for those five years, it seems like you’ve lost an opportunity because that money would have something like 40 years to grow in your RRSP. In your 30s or 40s, no question, pay off the debt. But in your 20s? I think it’s less clear.

• 5 TonyR // Feb 20, 2008 at 11:48 am

  I agree with paying off CCs. Paying off a CC with a 15% interest rate when you’re in a 35% tax bracket gives you an after tax return of 23% and zero risk. The RRSP tax savings will still be there in later years.

  Also, not maxing out your RRSPs makes sense to me if you’re around a tax bracket cutoff line. Contribute enough to get below the line and save the rest of the contribution room for later (assuming you expect raises.) Use the money you’d otherwise put into RRSPs to pay down the mortgage quicker.

• 6 WhereDoesAllMyMoneyGo // Feb 20, 2008 at 12:50 pm

  In some cases where there is no qualified beneficiary available, and the annuitant doesn’t need the money, they can start early withdrawals to transfer money to non-registered accounts to minimize taxes at death. An eye needs to be kept on the taxes on withdrawal, loss of sheltering, etc. so it’s not very cut and dry, but it’s an option for a few people - and a reason where saving more to an RRSP might not make sense.

• 7 Steve Heath // Feb 20, 2008 at 3:42 pm

  Brad - the quickest way to compare credit card vs. rrsp contribution is to look at the rates of return. Once the money is inside your RRSP it is before tax income, so if you are invested in the market, you might be making 7-10%.

  The credit card debt, however, is paid for with after tax money, so if your credit card rate is 12%, but you pay 25% of your income in taxes, you would actually be making a before tax return of 16% by paying it off (with zero risk).

  If the numbers are close, the one time tax savings might tilt it towards the RRSP, but if you are talking needing five years to pay off the credit card debt (ouch!) then it’s highly unlikely.

  The other alternative, of course, is to renegotiate your credit card debt into “better” debt… such as a consolidation loan with a much lower percentage or lumping your credit card debt into your mortgage… in that case, you might then get a higher return on your RRSP.

  Of course, if you haven’t bought your first home yet, you have a whole new ball of tricks to use… the RRSP Home Buyers Program… if you owe $10,000 in credit card debt and are paying a high rate of interest, you could just get a $10,000 RRSP loan and deposit it, and as long as it is in there for a certain amount of time (I think three months), when you sign a contract to buy a house you can then withdraw the funds. You then use the $10,000 you withdrew to pay off your credit card debt, use the $2,500 tax refund you get to lower your RRSP loan, and you are left with 3/4’s of your debt at probably the lowest possible interest rate. You then have two years of no repayments, and then 15 years when you would need to put 1/15th of the $10,000, ~ $670.00, back into your RRSP or count it as taxable income.

• 8 Canadian Capitalist // Feb 20, 2008 at 4:48 pm

  Thanks for your comments. Personally, I’d opt for the “sure thing” of paying down the debt and once the debt is paid off, channeling the debt payments towards a RRSP. It is hard to model whether a RRSP or debt paydown is better because we have to make multiple assumptions and who knows how many of those assumptions will be valid?

• 9 Steve Heath // Feb 20, 2008 at 5:03 pm

  CC - I would too, but to be fair, that’s because neither of us likes leverage

• 10 Phil S // Feb 20, 2008 at 5:19 pm

  But leverage is your friend. It magnifies your return and gives you a tax deduction for doing it. I currently have very little leverage, though, as we head into a US recession. I need to wait and see what the economic devastation looks like before I seriously consider any major leveraged investment strategies.

• 11 0xCC // Feb 20, 2008 at 5:38 pm

  Leverage magnifies your return in *both* directions. So you have to be comfortable with both the upside of leverage as well as the downside which I think a lot of people that aren’t experienced with leverage miss.

• 12 brad // Feb 20, 2008 at 5:52 pm

  @Steve Heath: I understand the rate of return issue, but here’s how I think time horizon plays into it as well:

  Let’s assume you’ll be able to pay off your credit card debt over three or four years. So if you have, say, $5,000 in credit card debt, you’ll be paying 19 percent or whatever over just three or four years years. But money you put into an RRSP is going to earn an average of 7-10 percent per year over 40 years. So to me it’s an issue of losing 19 percent in interest per year over three years versus earning an average of say 10 percent a year over 40 years, which seems like a much better deal. But maybe I’m missing a key part of the logic, it wouldn’t be the first time.

• 13 Steve Heath // Feb 20, 2008 at 6:23 pm

  Brad, you can’t ignore your debt over time either. Think of it this way… you have $2000 / year that you can use for one or the other, and your total credit card debt is $3000 at 20% interest.

  If you pay the card off, you have:
  Year 1 - $600 interest, balance $1600
  Year 2 - $320 interest, balance $0, $80 In RRSP, $20 in Tax Refund
  Year 3 - Gain $8 in RRSP interest, $2000 more in RRSP, $500 in tax refund.

  At the end of year 3, your net worth is $2608.00, and you now have 42 more years of compounding. More importantly, every year you can add $2000 more to your RRSP. If you split it in half…

  Year 1 - $600 Interest, Balance $2600, $1000 in RRSP
  Year 2 - $520 Interest, Balance $2120, $1000 more in RRSP, $250 tax refund, $100 interest = 1350 in RRSP
  Year 3 - $424 Interest, Balance $1696, $1000 more in RRSP, $250 tax refund, $200 interest = $2800 in RRSP

  In this case, your net worth is only $1104 at the end of year 3, and it will still be many years before you can put more than $1000 into your RRSP… in fact, if we look at year 4…

  (a) $2608 + $2000 in RRSP + $500 tax return + $260 interest = $5368 net worth
  (b) $339 Interest, Balance $1357, $1000 more in RRSP, $250 tax refund, $300 interest = $4350 in RRSP/assets = $2993 net worth.

  So you see, if you can pay off your debt in 3 years, but choose to extend it to say 10 years to contribute to your RRSP with those rates of return, the additional compounding you gain from years 1-3 is VASTLY outweighed by the lost compounding you get from years 4-10 from losing all that cash flow to the debt.

• 14 Steve Heath // Feb 20, 2008 at 6:24 pm

  Edit: Sorry, missed the $250 tax refund in year 1, but it doesn’t change the overall numbers significantly.

• 15 Lisa // Feb 20, 2008 at 6:25 pm

  I’m new at this, so this is the first time I’ve encountered “leverage.”

  Would that be like say:
  –instead of saving money to invest in an RRSP at the end of the year
  – taking out an RRSP loan at the start of the year, and investing it right away in something that earned interest?

  In my particular case, I think it makes sense — even though the loan has a higher interest rate than the investment.

  (Because I’d pay off the loan early, and the investment would sit there earning all year).

  Thoughts?

• 16 brad // Feb 20, 2008 at 6:54 pm

  Thanks, Steve, that makes sense.

• 17 Bob // Feb 20, 2008 at 7:35 pm

  No matter which turns out to be beneficial (paying off credit card or contributing to an RRSP) you MUST always get the debt off the credit card and onto a lower interest loan … which should be less than half the interest rate of a credit card. Never carry debt on your credit card.

• 18 Steve Priebe // Feb 20, 2008 at 10:03 pm

  Not yet mentioned…(1)

  One most prefer not to consider - premature death. At age 48, an actuary estimated that I, an average male, had a 7/8 chance of living to 65. Chances for many - especially males, especially police, fire fighters, ambulance attendants, especially those with cancer, diabetes etc - of enjoying full RRSP payouts may be too low to justify the foregoing of current income.

• 19 Steve Priebe // Feb 20, 2008 at 10:07 pm

  Not yet mentioned…(2)

  If confident of receiving a large inheritance before retirement or slightly thereafter, it might be of greater personal utility to spend now rather than save one’s RRSP contributions. Of course, one’s expectations for inheritance might never be fulfilled…

• 20 Steve Priebe // Feb 20, 2008 at 10:11 pm

  Not yet mentioned…(3)

  If planning to move to a foreign country before or slightly after retirement, or perhaps in the near future because of a job change, tax considerations for Canada and the other country might make contributions uneconomical.

• 21 Steve Priebe // Feb 20, 2008 at 10:13 pm

  Not yet mentioned …(4)

  Divorce on the horizon? Might want to spend the money now, or give it to charity or children, or save it for legal fees, rather than putting it in an RRSP.

• 22 Steve Priebe // Feb 20, 2008 at 10:16 pm

  Not yet mentioned …(5)

  Thinking tax rates are going up? Might be better to defer contributions from December of one year to January of the next, to get a bigger tax break.

• 23 Sol Veritas // Feb 21, 2008 at 10:36 pm

  Are RRSPs subject to:
  - bankruptcy?
  - divorce?

• 24 tracy ho // Feb 22, 2008 at 2:51 am

  Great to know that,

  Tracy Ho,
  wisdomgetingloaded

• 25 Weekly Dividend Investing Roundup - February 22, 2008 » The Dividend Guy Blog // Feb 22, 2008 at 10:39 am

  [...] For those of us in Canada, it is RRSP season and contrary to much of the marketing propaganda available from mutual fund companies and banks, RRSPs are not for everyone. This article by Canadian Capitalist addresses the question, “When Does a RRSP Contribution Not Make Sense?” [...]

• 26 Phil S // Feb 22, 2008 at 9:15 pm

  Lisa. “Leveraging” just means borrowing money to invest. The “leveraging” that we’re talking about (the tax deductible kind) is borrowing to invest in income-producing investments, outside of an RRSP. The government created this as an incentive for Canadians to invest in themselves, whether you are buying rental property, a small business, or some dividend paying stocks on the stock exchange, our government uses this tax credit to let Canadians take control of their own financial future. So, let’s say if you’re buying some coffee shop for about $100K and you have $20K of your own cash to invest, then you have to borrow, or “leverage” the remaining $80K, which is 4x your own investment. Obviously, you’re paying interest every month, so it’s best to try to pay back your creditor as fast as you can, but in the meantime, the interest on that money is tax deductible!

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