Ahh retirement. Aren’t we all thinking about that? Oh wait! We just started working.
When it comes to retirement, the most well-known financial savings instrument for Canadians is the RRSP account. It has almost become a ritual for most Canadians to run out and make their last minute contributions at the end of February before the deadline passes. That’s when banks open late and everyone picks up their phone to call their financial advisor or broker.
For those that are not familiar with an RRSP account, it’s similar to the TFSA account I wrote about in my previous post. There are some differences in the two accounts; however, one of them being that your contribution limit is tied directly to your annual income. This limit is 18% of your gross annual income, however, with certain deductions and support payments this value can change. It’s always best to get software or ask an accountant to compute what you limit is for the year. If you contribute more than you are allowed, just like the TFSA, you will get charged a penalty. Similar to the TFSA, your contribution limit accumulates. For instance, if you don’t contribute anything for 2012 then that contribution limit will be added to 2013. Your limit could really start adding up if you don’t put any money into the RRSP.
Despite being popular, a lot of people still have the wrong perception about the RRSP account. Here are some myths that we need to dispel.
Myth 1: It’s for retirement only.
This is not true. Despite the fact that “Retirement” is in the name of the account, the money that accrues in the account can be used for two other purposes. One is buying a home. The second is for your education or your spouse’s education, but not your children. There is a catch. The money has to be repaid back to your RRSP, but not immediately. If you are buying a home you will get 15 years to pay it back. For education purposes the payback period is 10 years. Failure to put the money back into your RRSP will result in taxes being paid on the withdrawal amounts. Why is using the RRSP useful? Well if you are saving for one of those two purposes, the RRSP lets your funds grow tax free while they are in the account. This could accumulate to a sizeable amount if you are trying to save for a house down payment.
Myth 2: I’m getting a tax refund.
Most people that put money into their RRSP do so because they think they are getting a refund on their taxes. This is incorrect. It’s actually a tax deferral. The reason why it’s a tax deferral is because when you take money out of an RRSP account you will get taxed on that withdrawal. It’s true that you may pay less taxes on the money you withdraw from your RRSP, but you may not be able to predict how much money you’ll be earning when you retire. It’s best to treat the the transaction as a tax deferral than a tax rebate, because eventually you’ll have to pay some taxes on that money.
Myth 3: I’m getting money back from the government
This is actually a tricky one. Most people will receive a cheque from the government when they do their taxes because they have paid too much tax. What’s actually happening is that the government is giving back your own money. If you are contributing to your RRSP on a regular basis (paying yourself first), then it is actually possible to get that “refund” right away. All you need to do is fill out tax forms at your workplace and declare it as a deduction right away. The government will be aware of your RRSP contributions and return that portion of taxes back to you by deducting less money from your paycheque. Why not get your money right away? It’s like owing your friend $50 bucks a month, but you give him $60 a month instead. 12 months later he realizes you paid him too much and gives you back $120. You didn’t get money from him, he just gave you back the money that was yours to begin with. So why give the government more money than they should be receiving? Keep it in your pocket. In an ideal world you should be getting nothing back from the government when you file your taxes. This means you budgeted well and you also paid the right amount of taxes throughout the year.
So now that we’ve gone through some of the misunderstandings, what do you get with an RRSP? Well you get an account where the earnings are tax free. As long as your money stays in the RRSP account, the gains you make are not taxed. This is great. It lets you grow your money without the government taking a chunk of it every year.
So what does an RRSP hold? For most mutual funds are popular, as are GICs and bonds. RRSPs can hold many types of investment vehicles just like a TFSA account. Finding the right mix for you will help you build a good nest egg for that special day when you no longer have to work.