As the annual RRSP contribution deadline approaches, it's worth considering more than just how much money you can afford to stash away. Specifically, it's worth thinking about taxes.
For many investors in registered retirement savings plans, the tax strategy starts and ends with deducting their annual contributions from their income. But this is a shortsighted approach that will likely lead to much larger tax bills than necessary down the road, financial advisers and tax specialists warn.
Investors must realize two essential things about taxes in a normal retirement, says Doug Dahmer, founder and chief executive officer of Emeritus Financial Strategies Inc., in Burlington, Ont. First, understand that they will consume more of your income than any other single expense. And second, recognize that the best opportunities for managing taxes occur in retirement.
"Most people end up paying higher taxes in retirement than when they were working," he says. "That's a terrifying thought. RRSPs were designed in such a way that I was supposed to save on taxes when I'm in a 42-per-cent bracket and pay taxes when I'm in the 25-per-cent bracket."
One of the factors at play in this calculus is that the government begins clawing back Old Age Security payments once a retiree's taxable income reaches $71,592. Another is that the government imposes minimum withdrawal requirements from RRSPs once someone turns 71 (at which point the savings must be converted into a RRIF, or registered retirement income fund).
Managing this puzzle starts with creating an investment plan long before reaching retirement. That blueprint should address two key questions: How much money will I need to retire with the lifestyle I want, and when will I need that money?
"RRSPs are important, but you need other tools in the plan," Mr. Dahmer says. "It makes sense to have as many types as possible – each with different tax implications – so you can create your own recipe."
These may include non-registered accounts holding Canadian dividend stocks – whose payouts are taxed at much lower rates than interest bearing bonds or GICs – as well as tax-free savings accounts (TFSAs).
Those whose retirement savings are limited to just an RRSP runs the risk of building a "tax trap" for themselves, Mr. Dahmer says. For example, a retiree who needs to make a one-time withdrawal to put a new roof on his home could easily push himself into a higher tax bracket with the extra income, triggering a bigger tax bill and the OAS clawback.
Most of Emeritus' clients – whose household incomes range between $150,000 and $220,000 – slow down or stop their RRSP contributions after they reach 55. Mr. Dahmer admits this is not the traditional advice offered by money managers, but he says it helps clients reduce their lifetime tax bill.
The money is directed instead at debt elimination and TFSAs. Any tax deductions available from RRSP contributions are kept for later use in retirement for "unexpected tax events," he says. These may include one-time payments such as stock options or severances, or an unplanned withdrawal from a registered account for extra cash.
"One of the biggest mistakes investors make is waiting until age 71 to begin withdrawing [RRSP funds]," Mr. Dahmer says. "They are creating a huge tax trap for themselves."
Instead, he advises clients to convert part of their RRSPs to a RRIF well before retirement and begin drawing it down. The goal is to take out just enough to push their income to the top of their tax bracket. "This is the cheapest you are going to get that money out," he says. "Take the tax hit in your late 50s or 60s and you will earn it back later on."
Part of Emeritus' approach relies on TFSAs, and other money managers are quick to point out that these saving vehicles have existed for just six years. As a result, the maximum aggregate deposit that can have been made to an individual TFSA by the end of this year is just $36,500.
"Taxes and fees are very important aspects investors need to manage and be able to control," says Paul Vaillancourt, executive vice-president of private wealth at Fiera Capital Corp. in Calgary.
Both RRSPs and TFSAs offer the benefit of disciplined savings, but the majority of Fiera's clients have RRSPs but not TFSAs, he says.
All but the most wealthy of investors face the challenge of optimizing the tradeoff between paying down debt and saving for the future, but regardless of the level of debt one carries, all investors need to save and shelter their gains as best they can, adds his colleague Claudio Gagliardi, a senior vice-president at Fiera.
Both men consider RRSPs the best vehicle for doing this. Investing in RRSPs helps defer taxes, not avoid them altogether. But spread out over decades of employment, tax deferral can be a very powerful thing, Mr. Gagliardi says.
He also suggests that if there is a large age difference between a couple, it may make sense to try to equalize income streams before the older spouse reaches retirement. The goal is to stay in the lowest possible tax bracket when one spouse has employment income and the other receives pension income.