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|
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%!
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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