Canadians have seen their investing choices multiply over the decades, both in terms of products and services and types of accounts.
In 1957, the registered retirement savings plan (RRSP) was born and gave individuals a way to create their own pension to help carry them through retirement. In 1974, the government introduced the registered education savings plan (RESP) to help families save for their children’s education. In 2009, we were introduced to the tax-free savings account (TFSA), another registered option.
Even though these accounts have been in existence for a long time, there is still some confusion around them.
Let’s start with the RRSP. The purpose of this vehicle is to incentivize an individual to save over the course of their working life in order to supplement their retirement lifestyle expenses over and above their Canada Pension Plan (or Quebec Pension Plan) and Old Age Security benefits, plus any government or private pensions they may have. The incentive stems from the ability to claim tax deductions based on contributions to the RRSP each year.
Many Canadians, both young and old, have come to me saying they should not have an RRSP.
It’s true that not all Canadians will necessarily benefit from an RRSP. For instance, those who have robust pensions will not have much or any RRSP contribution room. Others may not garner all of the tax benefits from having an RRSP or may even be disadvantaged down the road.
Let’s look at some scenarios. If I am in a higher tax bracket when I am contributing to an RRSP than when I start drawing out on or before the age of 72, then the tax benefits are greater. What I saved in tax from the deduction against income was greater than the tax paid on the withdrawal. If I’m in either the same tax bracket when I have retired or an even higher one, then the benefits aren’t as attractive. Canadians who find themselves in this situation comprise a very small minority.
Beyond those individuals who are simply making more money in retirement, there are those who may have benefited from an RRSP and either built an excessively large one or have reason to believe their life expectancy has been shortened. Canada does not have an estate tax, but Ottawa does have a stealth one for people who did the right thing by investing in an RRSP and pass away prematurely. That is because the full value of the RRSP (or RRIF, if older than 71) is treated as income in their final tax return. In either situation, a financial plan will help identify any advantages to making periodic withdrawals from an RRSP.
But overall, most Canadians could benefit from a sound RRSP strategy.
While there is no tax benefit from contributions to an RESP, the investments inside the account benefit from tax deferral. Like an RRSP, investment income generated inside the account is not taxed; only the payments received by the beneficiary – generally a child enrolled at a postsecondary school – are taxed, when they will likely have little other income and pay no tax or a low rate of tax.
While investment returns on an RESP are unknown year to year, a generous government grant is certain. The Canada Education Savings Grant adds 20 per cent to RESP contributions of up to $2,500 – as much as $500 a year.
Sometimes I hear people say they shouldn’t open an RESP for their child or grandchild because they may not pursue a postsecondary education. They should keep in mind that a postsecondary education is not limited to college or university; trades, from carpentry to hairstyling, would also qualify.
Let’s assume, however, that the beneficiary does not continue their education or cuts it short or just doesn’t require the money in the RESP because of an abundance of scholarships or employment income. The RESP will eventually be closed, but the holder of the account will only be taxed on income and growth. The capital comes out tax-free – after all, that money has already been taxed – and the grants will be returned to the government.
But where were those contributions going to be invested if not in an RESP? If in a non-registered account, the income would have been taxed at the holder’s marginal rate each year. I believe most children and grandchildren will pursue postsecondary education and, given the inflation in education-related costs, it is unlikely that a student will not use up most or all of the RESP.
Bottom line: Before you make a decision based on general advice, do your research and sit down with an adviser to review your unique situation.
Andrew Pyle is senior portfolio manager and senior investment adviser, CIBC Wood Gundy.