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moneysense.ca, 20/03/07
Reader Question about RRSP
Current issue:
Michael from Gatineau asked the following question about RRSPs:
Is there any benefit to them [RRSPs], if you are not going to wait until your retirement (or until you are in a lower tax bracket) to use them?
Say, if I’m putting money in some index funds for 5 years, and in 5 years I’ll probably be in a higher tax bracket than now. Would it be better to put that money in non-RSP funds so as to pay the tax now and now in 5 years?
I’ll assume that you need the money you are going to contribute to your RRSP in 5 years or so, for some specific reason. There are two parts to your question: (1) Should I put the money in an index fund? (2) Should I park the investment inside a RRSP?
In my opinion, any money you’ll need at a specific time in the short term should be invested such that your principal is guaranteed. Index funds fail this test because even if you invest in a bond fund, which has a low risk profile, there is no assurance that you will get your principal back. The only options that are left are bonds or GICs. You can either buy a 5-year bond or GIC whose maturity date matches your time frame or you could construct a bond ladder.
I think you are better off holding the bond or GIC in a taxable account. Your short time frame and the fact that you are likely to be in a higher tax bracket negate the advantages of a RRSP. A fixed income investment in a taxable account will be taxed at your marginal rate and your principal will barely keep up with inflation. Unfortunately, it appears to me that it is the best option for your situation.
moneysense.ca, 20/03/07
I can’t claim to understand his question but assuming you’ve interpreted correctly then I would agree that safety of principal is the top priority.
The only other idea I can think of as far as parking money is if you have a LOC with a balance then you can put money in there and then withdraw it when you need it.
Great post!
I am in a similar situation: I am a fresh university grad who works full time and has a solid income, but not enough to warrant contributing to an RRSP. I am also setting aside a fixed amount of money every week to use towards a house downpayment in 2-3 years from now. Naturally, these savings have to be in a “low risk” investment because I need the money in 2-3 years and don’t want to be stuck in a down market then.
I currently contribute weekly into a good, low MER, low turnover Canadian balanced mutual fund holding blue-chip Canadian equities and high-quality Canadian bonds.
I am a huge fan of passive index investing, and I am tempted to put my money into an index ETF or an index mutual fund, the latter allowing me to continue contributing. Would something like the iShares Canadian Bond index be too “risky” if I need money in 2-3 years?
jml – you should look into the Home Buyers Savings Plan. It allows you to withdrawl up to $20,000 per spouse from an RRSP tax free for the down payment on a house. There’s more details to know, but it should make it worth your while to contribute to an RRSP as part of saving for your house.
JB: I did consider the HBP, but then I am in the bottom tax bracket and contributing to an RRSP would give me negligible tax savings and would impose a lot more restrictions on my money. Seeing that my tax rate is low, I decided to pay taxes on my income and accumulate money outside of an RRSP for 2-3 years then plow it all into a house downpayment. This way I would not have to worry about replenishing the RRSP, and I also maintain the carried-forward contribution room that I will take advantage of when I am in a higher tax bracket.
jml: Yes, bond funds have a low risk. Historically, I cannot find two consecutive years when bonds total returns were negative. The worst year was 1994 when bonds returned -4.3%. I think you are better off to invest your money in a high interest savings account. Don’t forget commissions if you buy ETFs.
You can also contribute to your RRSP and not deduct it against your income this year and carry forward to a future year when your income will be higher. The earnings on your capital will then be sheltered from tax and you could withdraw $20K under the HBP.
I don’t know how much money you’re looking to sock away, but if you’re looking at a substantial amount of cash, you should consider using a corporate structure. In other words, put the money into a corporation that is a holding company. The interest or dividends or whatever would accumulate inside the corporation and be taxed at a much lower rate (corporate rate) than in your own hands (personal tax rate). When you need the money, you can collapse the corporation and take it all as capital gains instead of interest income. There is some other financial wizardry that you can add to that structure. For example, the holding company operates out of a room in your apartment, so it has to pay a part of your rent and utilities, yada yada.
^ That is a very “Robert Kiyosaki” approach that most likely isn’t feasible. The CRA is probably smarter than the average person who tries to evade taxes using a shell/front corporation. Why would I want to pay tax twice on my earnings that will be used in 2-3 years to buy a house? Don’t forget the costs, reporting requirements and legal hurdles that are needed to form a corporation in the first place.
I suggest that those of you who are interested in acquiring a truly accurate answer to the type of question posted visit the RRIFmetic site ( http://www.fimetrics.com/ ).
Fred
^ The question has little to do with RRIF, retirement and estate planning. That site and its product would not help. Spam?
The original question was to find out if it is prudent to stow savings in an RRSP if those savings need to be used for a purchase in 5 years.
Honestly, if the money is only being socked away for 2-3 years, a high-interest savings account (ING, President’s Choice, etc) would be all that’s needed. The Home Buyer’s Plan is meant for people that already have significant RRSP assets that they want to draw upon to buy a house, not for people that don’t yet have money in an RRSP.
Similarly, setting up a “shell” corporation is a pretty crazy idea for something like this, and won’t likely result in any significant tax savings. Usually people saving up for a first home don’t have really high incomes, so any taxes on the interest income won’t amount to much in any event.