We have a motley little group of people who get together for what we call Money Mondays. Last week I spent 8 hours doing the write-up below & accompanying deck. It isn’t edited & it’s meant to give an overall view, so it is very lean on details. However, I thought some people may enjoy it so I’m posting it below.
Having said that, I have also recently come across these three interesting articles on retirement, which I found super informative.
Running out of time before running out of money
Most retirees will never spend down their portfolio
TFSAs vs. RRSPs
Basically, the way you should look at them is as if they were buckets. They are just holding places for where you put your money. On their own they are nothing – just places where you can stick money. If you put $100 in each of them today, you would have $100 in 20 years.
BUT, within the buckets you can hold almost any kind of investment: bonds, index or mutual funds, GICs, etc. (OBVZ not real estate) and the investments are allowed to grow tax-free within these buckets.
Lexicon issues
Part of the confusion surrounding these two (buckets) is the way the finance industry speaks about them. For example, “my RRSP made $1000 in interest last year” is technically correct but what it really means is, “the investments INSIDE my RRSP made $1000 in interest last year.” Some people think they can just stick money into the bucket and leave it. You can but you won’t make any interest on it. Unlike the low interest you may get in chequing and savings accounts, TFSAs and RRSPs generate ZERO interest on their own. You need to choose an investment to generate interest.
What the hell is a pre-tax dollar? The language around RRSPs is often confusing with many articles stating that you will “get half of the money back” when you contribute to an RRSP. That *can* be true – if you are a high-income earner – but it is generally much less than this.
A pre-tax dollar means that you can save money in an RRSP BEFORE the government taxes your salary. So if you make $55000 a year, and you put $6000 into an RRSP, the government treats your income as if you had made $49000 instead. So the government returns the taxes that you “overpaid” on that $6000 when you contributed to your RRSP.
With Group RRSP plans and Pensions, your Pay & Benefits department usually already adjusts your salary based on your contribution. So you get more in your pocket every pay but you won’t see as much of a “return.”
What the hell is an after-tax dollar? That is basically money from your NET pay. You’ve already been taxed on it.
Two notes
Tax brackets: If you will notice in the above example as well, an RRSP contribution can bring you down a tax bracket:
– On the first 0-$49020 the tax rate is 15%
– On the next $49020 to $98040 the tax rate is 20.5%
– By contributing to an RRSP, that (appx) $6000 is escaping the fate of being taxed at 20.5%
(we can discuss how progressive taxation works another time)
A note on pensions: You will notice that above I mentioned that Pay & Benefits departments usually reduces your tax-payable at the source when calculating how much tax to take off of your paycheque. That is because Pensions and RRSPs use the same contribution room calculations. So if in 2021 you contribute $20000 to a pension (if you are in the max RRSP category), you will only have $7830 left in contribution room should you decide to contribute to an RRSP. It’s all treated as retirement savings.
So how do I choose which one to contribute to?
The basic rule of thumb (I hate rules of thumb) is that if you make less than $50000 you should contribute to a TSFA and if you make more than $50000 you should contribute to an RRSP. But those rules only apply if you DON’T have a pension.
If you do have a pension? Likely, a TFSA (unless you want to retire early).
If you don’t have a pension? Ideally: both. If you can’t do both, RRSP.
The reason for this is that the RRSP is actually a TAX DEFERRAL PROGRAM. The way it works is that you contribute to your retirement during your high-earning years and receive a tax incentive to do so. Between now and retirement your nest egg will grow significantly & tax-free until you go to take it out. The logic is that when you retire your income will be reduced significantly so that when you take money out of your RRSPs you will be in a smaller tax bracket.
A very simplistic example
So let’s play with an example. Say you make $65000 a year and because you are super diligent and amazing and basically don’t exist, you max out your RRSP from the time you are a wee bairn with their first job. So you contribute the maximum – $11700 a year – until you are 65. Give yourself a pat on the back, you non-existent person you!
To make it easy for our example, we are going to assume that nothing changes (no raises, no tax bracket changes, market doesn’t crash etc.) but guaranteed all these things will change. Still, we put our money into index funds which make us a return of 5% a year, compounded for 25 years. So it looks like this:
$11700 x 5% with $11700 added every year and compounded over 25 years = $621353
Another rule of thumb (ugh) is that you need 70% of your working salary as your retirement salary. In the case of this example, that would be a gross income of $37310*.
So without getting into the niggly details, let’s assume that the government is going to give you $18000 a year** meaning that if you want to hit that $37310 amount you are going to have to take out $19310 from your RRSP. Luckily, you have it!
But the devil always gets his due, WHOMP WHOMP and you find yourself paying taxes on that $19310, which means you have to actually take out $22207 to pay off your $2897 tax bill.
Still, when you were working you had been paying 20.5% on any money you made over $49000 so you got a bit of a break there and you saved yourself 5.5% in taxes on the $11700 you put into your RRSPs, so it’s a minor win.
Still, even when the tax brackets don’t switch or the amounts are marginal-to-poor, the biggest boon is the ability to have your money grow and make money within the RRSP without paying capital gains on it***. Had you saved the $11700 a year and not invested, you would have $292500 – a far cry from the $621353 above!
*Wait! Why not $65000 x 70% = $45500?! Because I am calculating it on $53300 because that is what you were living on BEFORE as you had actually put $1170 into RRSPs every year: 65000 – 11700 = 53300.
**They won’t
***Capital gains are when you make money on something, 50% of the amount you made is added to your salary and taxed at that tax rate.
We’ll get to more on Pensions, TFSAs and taxes in a minute but wait, there’s more…
A note for Chicken Littles…
A lot of gums flap about how programs like CPP/OAS/GIS won’t be there or will be bankrupt when we go to retire. Honestly, CPP itself is in a pretty healthy state so far which is also why you are seeing the rates go up a lot. I love when I see old, cranky Conservatives go on about how THEY PAID INTO IT and how they want more but none of us really pays what we put in if we live to a ripe old age (some of us will die early and thems the breaks!). CPP is at its core a pyramid scheme so as long as people are working and paying, the longer it will exist.
Also, if these programs go POOF likely the entire economy – or maybe society itself – has collapsed and we’ll have bigger worries than this. I think the finance industry has a vested interest in convincing us to save more by convincing us we can’t rely on it.
Screw rules of thumb, a diatribe
So you aren’t – and I am certainly not – average. A friend and I have discussed our retirements together and she can’t see her expenses going down by 30% at all! So she will need to adjust for that shortfall.
In fact, this is the case for a lot of retirees who often travel, take up hobbies, help grandkids etc. Also, more and more people are heading into retirement with debt be it a mortgage or consumer debt so a reduction just isn’t feasible. We won’t even speak about disability or the price of an LTC!
Conversely, in my household we are spending a lot of money raising two kids as well as saving for their educations. When the girls leave so many of the categories in our budget will go down, from clothes to food to entertainment. Even still, our family is currently on an extremely tight budget for the next three years and we are saving over 50% of our income. What this tells us is that when Mr. Tucker retires, we can reduce our budget exponentially in a couple of different ways and still leave us a pretty good life.
So look at your situation and see if you fit into the industry’s perfect idea of a retiree, I bet you may not!
Choose your own adventure! I have a pension:
If you have a pension, you don’t want to have a HUGE RRSP (unless you plan to retire early but that is an ENTIRE presentation in itself). That is because pensions replace 70% of your income already and when you take money out of an RRSP that gets tacked onto your taxable amount. That’s not particularly bad if you want to take out a few thousand a year but once you hit 71, all hell breaks loose.
At 71 the government forces you to turn your RRSP into an RRIF. We can discuss those in detail at a later date but what is important to remember is that in a RRIF the government FORCES you to take out a percentage of the money every year. The amount increases the longer you live (you can see a chart here) from a 5.40% withdrawal rate at 72 to a 20% rate at 95 or older! So if you have a pension bringing in $60000 a year and you are 80 years old with a RRIF worth $600000, the government will force you to take out 6.82% of your RRIF bringing your taxable salary up to $100920! OUCH IN THE TAX PLACE!
So this is why it is recommended that people with pensions hit up the TFSAs first. If you were 18 before 2009 you have $75500 worth of lifetime contribution room and it goes up (appx) $6000 each year. The money still grows tax free from your investments in the TFSA bucket but the difference is that you aren’t taxed on the money when you take it out. So you won’t get fucked in the butthole by the forced RRIF withdrawal rules.
Different situations:
– It could be worthwhile to contribute to RRSPs as well, especially if you feel you want to top up that 30% that your pension doesn’t cover. I would do the math to figure out the TFSA vs. RRSP contribution amounts.
– If you have a common law partner without a pension, you can income split at 65. You can also split RRIF income so if your spouse made significantly less than you during your working life, spousal RRSPs or splitting RRSP/RRIFs may be right for you.
– If you plan to go to school in the future you may want to contribute to an RRSP to get the tax benefit and to take up to $20000 out for the Lifelong Learning Plan (LLP). The LLP can be used for you OR YOUR PARTNER. You have to pay it back within 10 years but it’s better than a loan.
– If you plan to buy a home and want to use the Home Buyers Plan (HBP). You have to be a first-time home buyer to use the HBP (there are exceptions such as disability) and you can take out $35000 and have to pay it back over 15 years. Again, good if you want to take the tax break and buy a home.
In both the above scenarios, even having $55000 to get an education and buy a home won’t drown you if you have to use an RRIF down the road so it may be a good idea to have some money in RRSPs even if you have a pension.
Choose your own adventure: I don’t have a pension & don’t make a lot of money:
The TFSA was really a program brought in to allow low income earners to save money and reap benefits that the high-income earners got with the RRSP. Since you don’t save a lot in taxes when you are a low income earner, the only real benefit of the RRSP before the TFSA came along was the lack of capital gains on what your investments made.
The TFSA works well because the amount you take out of it isn’t clawed back by the government programs. If your primary source of income is going to be CPP/GIS/OAS using TFSAs means that when you take out money without having your primary source of income reduced. When you use RRSPs, that changes your calculation of your yearly income thus reducing the amount from government programs.
Right now – let’s assume you have never contributed to a TFSA – if you were 18 in 2009, you have $75500 in contribution room in your TFSA. You will also get $6000 worth of room for the next 20 years. Assuming that you decide today to max out your TFSA by the time you are 65 and you are 40 now, you will need to contribute $9020 or $752 a month for the next 25 years. At the end of that 25 years at 5% compounded, you will have $479225.
I admit, that is really high for a low-income earner in after-tax dollars. But let’s do the math with various amounts:
$100 – $63729
$150 – $95593
$200 – $127458
$300 – $191186
It could also just look like you using your tax return to fund your retirement.
Choose your own adventure: I don’t have a pension but I make a good salary:
This is where RRSPs truly shine! You want to max that 18%, baby! Did you already do that? Let’s hit up that MOFO TFSA for some investment action! Honestly, you can’t really go wrong here. Just put all the money in all of the things, is your motto! I think it’s unrealistic to think you will have $33830 to max them all out but maybe you do? I don’t know your life!
Your situation is similar to the non-pension low-income earners except you probably have a more high-falutin’ lifestyle you will need to support. So you are better off taking the tax break now, having more money down the road, and accepting the clawback on government benefits.
The HBP and the LLP are both great programs that you should take advantage of if you want. A strong caveat that if you can both save for a house/education AND max out your RRSP you should do that. Losing 15 years of interest payments can really hurt the end result of your retirement strategy.
You can also pension-split RRSPs/RRIFs when you are 65 so it may be worthwhile to run the numbers on how to fund an RRSP. For example if the husband’s 18% is $20000 but the wife’s entitled to the maximum of $27830 and you only have $30000 the smarter thing would be to fund the higher-income earner from a tax perspective because you can income split down the road AND you are probably dodging the highest tax bracket.
Choose your own adventure: I don’t have a pension but my work has a group RRSP:
Max it out. It’s free money. Don’t ever say no to free money.
Most employer-sponsored plans have rules such as:
– Company will match 100% of your contributions up until 3% of your gross salary
– Company will then match 50% of your contributions up until another 3% of your gross
Honestly, it’s the best deal going. Turning it down is like saying no to a 4.5% pay raise.
So which is better TFSA or RRSP?
This argument has gone on forever with some people claiming that they are equal and some claiming that one is better than the other. I feel like it’s splitting hairs but here is a really long and complicated article detailing everything you need to know about TFSAs/RRSPs/OAS/CPP/GIS. Sadly, the answer is always: DO THE MATH.
At the end of the day just save something, anything, somewhere, hopefully in an investment that AT LEAST beats inflation.
One of my favourite quotes is “The best time to plant an oak tree was 20 years ago. The second best time to plant one is now.” If you are feeling overwhelmed and behind right now please don’t, you are not alone. At the end of the day doing something is always doing nothing and even if you don’t manage to get a million dollars in the bank would you rather be 65 with $100000 in the bank or 65 with nothing? It may not seem like a lot of money in the grand scheme but it is money that could dig you out of a very big hole if you need it!
Note: I use The Calculator Site but if you want to use your own, YMMV.