November 2010

Can you go wrong with an RRSP?

An RRSP is a fantastic tool for building a retirement nest egg, but…

Most people concentrate their wealth in three main assets:  house, pension fund (if they have one), and RRSP. That shows how important the RRSP has become to our financial security – and how serious the consequences of an RRSP management error can be. Watch out for the following “red flags”.

1.     “Buying RRSPs”
Many people think that “buying RRSPs” from a number of different financial institutions is a way of diversifying their investments. However, the result is often the opposite:  they find themselves with different investment funds that are in fact strongly correlated. As well, tracking these investments with different maturities on different statements becomes unnecessarily complicated. It’s easier to implement a diversified strategy if all your investments are in the same RRSP.

2.     Waiting
An RRSP offers you a compound return over many years:  you make money on the money that you make. But the longer you wait, the less you benefit from this dynamic. The rule is a simple one:  contribute to your RRSP very early in your life and very early in the year (or throughout the year).

3.     Not contributing enough
Contributing just enough to your RRSP to offset the taxes you would otherwise have to pay in April is a big mistake. You need to decide how much money you will need during retirement and tailor your contributions to that amount.

4.     Contributing too much
Excess RRSP contributions (more than your contribution limit) result in penalties and interest. Plus, keep in mind that your RRSP is just one component of your financial security. You also need to have an emergency fund and protect yourself with the right insurance.

5.     Making asset allocation mistakes
If the size of your portfolio allows you to have investments both inside and outside of your RRSP, it is generally better to hold fixed-income securities (such as bond funds) inside and stocks (such as equity funds) outside. This is because what you earn from fixed-income securities is fully taxable if not in an RRSP, while capital gains and dividends from stocks are only partially taxable.

6.     Cashing in an RRSP for the short term
Amounts you withdraw from your RRSP are added to your taxable income and also taxed at source. Suppose that in order to make a withdrawal, you have to sell a $20,000 investment on which you take a $4,000 (non-deductible!) loss. This makes your withdrawal $16,000... less the 30% deduction that is immediately applied. You have wasted a $20,000 investment to get barely $11,000, not counting the remaining income tax you will have to pay in April.

7.     Claiming the tax deduction in the wrong year
Nothing says you have to claim your RRSP deduction in the year that you make your contribution. If you expect your income and your tax rate to increase in the future, you can carry your deduction forward and end up with greater tax savings.

8.     Repaying yourself, but not paying yourself
The Home Buyers’ Plan (HBP) is a wonderful tool that allows you to use RRSP money to buy your first residence. However, if you spend the next 15 years doing no more than repaying this money into your RRSP, you will lose 15 years of tax-sheltered compound growth. It’s important to keep on contributing “new” money every year.

9.     Spending the tax refund
The income tax refund that you get in the spring is not a gift:  it’s your savings being returned to you. If you really want to put it to good use, reinvest it immediately in your RRSP, or use it to pay down your debts.

10.  Forgetting to change the beneficiary
If you have designated a beneficiary for your RSSP, make sure this information is always up-to-date, so that your heirs don’t get a nasty surprise.

11.  Not adjusting the strategy over time
During the market downturn of recent years, many people watched their RRSPs tank just as they were about to retire. Where you are in your life cycle is important for setting your RRSP strategy.

12.  Waiting for RRSP season
In February, financial services professionals work 15-hour days. Choose to make periodic contributions instead, and sit down with your advisor at a time that is more convenient for both of you.

This list isn’t exhaustive, of course, but if you recognize yourself making one or more of these common mistakes, it might be a good idea to think things over sooner, not later. Your financial services professional is there to help you!