It is hard to get away from the ads for Registered Retirement Savings Plans (RRSPs) at this time of year. Every bank is encouraging you to make a contribution because it will mean a tax refund. They will even loan you money to make a contribution. But before you make an RRSP contribution, you should decide if it is the right choice for you.
We all want to retire at some point, so saving money for the future is a good idea. And RRSPs are one of the best tax shelters available to Canadians. But RRSPs do not offer a great deal of flexibility if you need to withdraw the money early, and you will be taxed on your RRSP withdrawals once you turn 71.
There is also a misconception about the tax refunds RRSPs can provide. Contributions are deducted from your taxable income, so they do result in tax savings. For example, if you earned $30,000 in 2012 and you contributed $2,500 to your RRSP, you will only pay tax on $27,500. But what does this mean as far as your refund? As a general rule of thumb, for every $1,000 you contribute to your RRSP, you will receive about $150 in federal tax savings, plus some provincial credit.
So depositing $5,000 into your RRSP will not result in a $5,000 tax refund. This is important to remember, especially if you are taking out a loan to pay for your RRSP contribution.
The amount of money you can deposit into an RRSP is determined by your income, up to a maximum amount. Your contribution room is included on your Notice of Assessment. You may not be able to use your limit right away but as you begin earning more income, the room will still be available.
If you withdraw money from your RRSP early, you immediately lose the tax benefits and your contribution room. The withdrawal is considered income and you will receive a T4RSP to report it on your tax return. Your financial institution is required to withhold a certain percentage for tax purposes, based on the amount of your withdrawal, but this amount may not be enough to cover your tax bill. It will depend on your income for the rest of the year.
There are two exceptions. The Home Buyers Plan allows first-time homebuyers to borrow up to $25,000 from their RRSP to buy a home without penalty. But you have to pay the amount back within 15 years or the withdrawal is considered income. And the Lifelong Learning Program allows you to borrow up to $20,000 from your RRSP to fund post-secondary education. The repayment has to happen within 10 years or, again, it is considered income and you will pay tax on it.
Tax Free Savings Account
RRSP used to be the only tax shelter available to save for retirement, but the Tax Free Savings Account (TFSA) was introduced in 2009 and offers more flexibility for saving. Unlike an RRSP, you can withdraw money from your TFSA without reporting it on your tax return. And you do not lose your contribution room, although you need to wait until the next calendar to re-deposit funds.
Your TFSA contribution room is not tied to your income. For 2013, the annual contribution limit is $5,500, regardless of how much you make. And a TFSA does not need to be just a regular savings account: there are options which offer greater returns but, like with most things in life, bigger rewards mean higher risk. Make sure you understand what you are investing in before you make a deposit.
So if you need access to your money or you are saving for shorter-term goals, the TFSA may be a better option than an RRSP. But there are penalties for over contributing so make sure you understand the rules when you open your account.
Thinking about retirement when it is still 30 or 40 years in the future may be tough, but saving early is the best strategy. Treat your retirement savings like another bill, so you get in the habit of depositing. It may be easier for your budget to make a monthly contribution rather than trying to come up with a large sum as the deadline looms.
And before you open an RRSP or TFSA, make sure you understand the risks involved and where your money is being invested. If it seems too good to be true it probably is, so pay attention to your money. You may not withdraw it until you retire but you want to ensure it is there when you decide to stop working.
The experts CBC News spoke to were unanimous on the need for a plan that takes volatility into account. "I meet so many people who don't have an investment plan - who won't have an intentional allocation to bonds, stocks, cash," says Edmonton-based financial educator Jim Yih. Having a plan is one of the best ways to increase your probability of investment success in the long run, he says. "It's hard not to pay attention to the swings," Yih acknowledges. But having an overall investment strategy and target asset mix makes it easier to avoid being caught up in the emotions of a plunging market. Sticking to that plan, of course, is a critical part of coping during the big slides.
Yih also says investors would be well advised to figure out their risk capacity - how much risk they need to take to reach their goals. This is not the same as the usual risk tolerance measures financial companies use, which he says "test how much risk you want to take." In addition to a financial plan, some advisers we talked to mentioned the importance of having an investment policy statement (IPS). This document determines how investment decisions are made. "The IPS gives you your rules for managing your investments, and when you believe in your rules, you will be better able to manage your response to wild market swings," says Warren MacKenzie, CEO of Weigh House Investor Services. But he notes that an IPS still isn't offered by many financial advisers, so you may have to hunt around. David Chilton, author of The Wealthy Barber Returns, points out that people often think they can handle a lot of volatility - in other words, a lot of risk. That is, until the market actually undergoes a severe correction. "Figuring out how much volatility you can stomach ahead of actually experiencing that volatility is an inexact process," he writes. "For most of us, it's less than we think."
Is the investing concept of "buy and hold" through thick and thin really dead? Some advisers think it's time to at least revisit this familiar maxim. "Buy and hold is a great strategy if you are in a bull market," Warren MacKenzie says. "But if we're in a secular bear market - and I believe we are - buy and hold is the worst strategy." Now is the time to hire a professional manager who can buy and sell to take advantage of that volatility, MacKenzie says. "You must realize that to be a successful investor, you have to buy when the news is bad and when other investors are selling," he adds. Look at volatility as an opportunity to make money, MacKenzie says, because most people sell when the market drops and buy when it's near the top. Hiring someone to carry out your buying and selling also allows that third party to be the sober second thought your first impulse to panic needs - someone who isn't as emotionally involved with your money as you are.
Some advisers aren't quite willing to entirely write off the buy and hold philosophy, but do agree that market dips can uncover good quality stocks that have gone on sale. "Volatility can represent a buying opportunity if the fundamentals are sound and the price has dropped," says Cherith Cayford, a principal with Victoria-based CMG Financial Education. Cayford isn't ready to declare buy and hold dead just yet. "It still makes sense for quality blue chip investments." But she adds that it's vital to have cash available for those market opportunities that dips can produce. The buying doesn't have to be an all-or-nothing process, either. Instead of biting off more than you may be able to chew, you can nibble - investing a portion of your cash when the investment drops to an attractive level.
There are plenty of other investments that historically don't tend to move as dramatically as the stock market as a whole. So don't be surprised if your adviser suggests an increased allocation to alternative products or asset classes to reduce the riskiness of your portfolio. Government bonds, for instance, tend to be much less volatile than equities. But be aware that even long-term government bonds aren't yielding much these days. Utilities, telecoms and real estate investment trusts (REITs) are all less volatile than the dominant TSX sectors of energy companies and financials, while still paying reasonably high dividends. Preferred shares also fall into this category.
For some investors who can't escape the daily litany of depressing economic stories, some advisers suggest that turning a blind eye to the latest swings may be the best coping strategy. "Headlines can certainly be disconcerting," admits Marc Lamontagne. "You have to focus on your long-term goals." "In some cases, I have recommended clients stop opening their quarterly statements." This is, he points out, not a good long-term strategy for people who don't have a professional managing their investments. These days, the do-it-yourselfers need to pay even more attention.
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