RRSP season is here again and the banks are stepping up their marketing campaigns to encourage you to contribute.
Just to be clear, saving for retirement is of vital importance for everyone who wants to maintain a comfortable lifestyle as the years wind on. While contributing to an RRSP is a great thing to do, many members of the younger generation don’t take into consideration 2 very key issues, age and temptation.
For those of us that are just starting out in the workforce or have been working for only a few years, RRSPs may not be for you. Here’s why.
Tax benefits really kick in later in life
An RRSP is a vehicle for delaying and reducing tax and as a new member of the workforce you will probably not be paying much of it! As you earn more money over the years, your tax burden will increase which then makes the tax benefits of RRSPs more attractive. Here’s an example:
Michelle, who works in Alberta, starts off her career making $40,000 per year. Her average tax rate is just 16.2% or $6,648 per year. Since Michelle has skills that are and will continue to be in demand, her income will gradually increase as the years go on. I’ll put this into a table to better illustrate the concept.
| Age | Income | Average Tax Rate | Tax Paid |
| 25 | $40,000 | 16.62% | $6,648 |
| 35 | $70,000 | 22.94% | $16,059 |
| 45 | $100,000 | 26.24% | $26,242 |
| 55 | $120,000 | 27.87% | $33,442 |
| 65 | $130,000 | 28.49% | $37,042 |
Now let’s take the rule of thumb that many of us will require 70% of our pre retirement income in retirement. This means that since Michelle’s income topped at out at $130,000 per year she’ll need an income of around $91,000 per year to sustain the lifestyle she will have built for herself by then.
Now the punch line, with an income of $91,000 in retirement her average tax rate will be 25.28%. If Michelle is looking at RRSPs purely from a tax advantage perspective, she would only start to benefit around the age of 45 when her average tax rate reaches 26.24%!
*Update*
A often overlooked consideration for RRSP contributions is that the tax deduction can be deferred to later years when you have a higher income like this example illustrates. While this is beneficial on one hand, you won’t receive the tax refund until down the road. The refunded tax money could be used to pay down debt (credit card, line of credit, mortgage, etc) or re-invest in stocks, bonds or other investment products. Determining which strategy to use largely depends on personal circumstances.
You’ll be tempted to spend RRSP tax “refunds”
What about the tax “refund” that you’ll get as a result of contributing to an RRSP? I’m sure many people have contemplated taking a nice vacation with the money they received from the government.
Don’t think of the tax money you receive back from the government as a windfall. This tax refund actually represents the money you will have to repay the government when you start withdrawing funds from your RRSP at age 71!
If you spend this money, you are setting yourself up for financial difficulties down the road.
If Michelle were to contribute $5,000 to her RRSP, she would receive back $1,250 from the government. For many people in their 20’s and early 30’s who have numerous demands on their finances, this extra cash may get spent on dining out, drinks and vacations. This money needs to be put to good use either by paying down debt or re-investing it.
What should you do?
- When you are just starting out in your career, save your money. You will need it for buying a car, home, paying off student loans, credit cards and more.
- If you have repaid all of your high interest debt and have an emergency fund to cushion you from unexpected events, contribute to a TFSA. They are more flexible.
- As you move up the income ladder and your tax rate starts increasing, or you max out your TFSA, start contributing to your RRSP. The timing for this will be different for everyone, don’t start too late!
- Use your tax refunds to either further pay down debt or re-invest (preferably in your TFSA if you have room)
While the older generation has more experience with retirement planning, the younger generation does not. We can easily be led down a path that might not be right for us. To give the older generation credit, the TFSA is a recent invention which they did not get the benefit of in years past.
The bottom line is, you need to save your money, it’s just a question of where you allocate your savings in the early years. There is no substitute for having money invested over the long term.
Don’t get lured in by the marketing put out by the big banks, know when the right time is for you to get on the RRSP bandwagon!
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Is this article for real? You are actually suggesting that young people should delay their retirement savings? You do know that you can contribute to an RRSP and delay taking the deduction on your taxes until you’re in a higher tax bracket?
RRSPs are absolutely the best vehicle for retirement savings for young people. If we want to talk about temptation, TFSAs can be accessed anytime throughout life. The fees and rules surrounding RRSPs provide a safety net against our overwhelming urge to remove savings for a great vacation or a new car. And I’m not really sure if the temptation to spend the RRSP tax refund ever diminishes over time, you just find new things you want to spend it on.
RRSPs allow all investments, including U.S. and international products, to grow tax free and without any withholding fees. No other retirement option gives you that.
I do hope young people reading this article do some more research before taking your word. Take a look at a compound interest calculator using contributions beginning at age 25 and then beginning at age 45 (as the example above suggested) – those 20 years of compound interest lost will be significant.
I’m 30 and have been contributing to my RRSPs for 10 years now. Some years I could only afford a few hundred bucks and some years it was a couple thousand. I save my deductions for years where I am in a higher tax bracket and then only use enough of them to push me back below the bracket threshold. So now my money has 20 more years to grow than in your example and I’m still benefiting from the tax deductions in a higher tax bracket.
Hello, I’m ashamed of this article as it has left out many key factors that prove that the RRSP is a wonderful vehicle for many young people.
Please note, I am a 36 year old man, and have a moderate income, who’s maxed out my RRSP every year since I was 18. As you stated in your article, I reinvested my tax returns into an “open money” account.
The first issue here is your “fantasy numbers” for Michelle amazing raises in her income. Where did you get these numbers? Are they based on actual numbers of incomes across Alberta? Canada?, or did you just pick the numbers out of your head? Please let me know what Michelle does for a living as my annual raises are nowhere close to the 5%-6% she is getting year to year, and I would argue that at some point in the first 15 years of her career, she will get to a point where she is only getting an economic increase.
Next, you completely leave out the discussion about the compound interest benefit of starting much younger.
Your comment “If Michelle is looking at RRSPs purely from a tax advantage perspective, she would only start to benefit around the age of 45 when her average tax rate reaches 26.24%!”. This is a horrible way to look at RRSPs. They should be looked at for their ability to make compound interest, and tax delay advantages, for younger people before priorities shift in their lives
Also, there is no mention of delaying your RRSP deduction for later years (if you want to follow the model of the RRSP purely from a tax advantage perspective) when you make more, to take advantage of exactly what you’re talking about in your article, your “higher earning years”. Saving a little every year, is a lot easier than trying to throw a big chunk of money down to “Max your Tax savings” as per your model.
I do appreciate you explaining that the tax refund should be re-invested, and the TFSA is a great vehicle for this (as now you have something growing tax free and all the wonderful compound interest that goes along with it). So in essence, the government is giving you back your taxes to invest over your entire career and then asks that you start paying them back with their own invested money. However, your comment about “demands on a young person’s income” makes me cringe. “Nights out, drinks, and vacations” are not “demands”, they are “benefits of disposible income”. You could argue that in your early career years, you probably have the most disposible income, before, the cost of kids, real estate, and car payments use up much of that income. Because I maxed out my RRSP early in my career, and reinvested my refund, I was able to put 20% down on my first home, thanks for giving me my downpayment, Government of Canada.
You have stated that the rule of thumb that many people require 70% of their salary in retirement and Michelle will need $91,000 at retirement. How is she going to accomplish this if she waits until 45 before starting to invest? Starting an RRSP early as “forced savings”, helps young people develop good investing habits that they will continue to benefit from their entire lives.
Finally, your “what should you do” section leaves out the most important thing a young person can do. BUDGET!!! That should be #1 on everyone’s financial plan, especially young people. In your budget, leave room for investing. Buy a car and house you can afford, and paying off credit cards? If you don’t pay off your balance every month, you’re not sticking to the BUDGET!!! Don’t buy things you can’t afford.
Start young, take advantage of compound interest, and give yourself the good saving and investing habits early. The RRSP is a great vehicle to help you kickstart your road to wealth.