Andrew Pyle
February 10, 2023
Your saving strategy should be based on facts, not hearsay
We are quickly approaching the middle of February - a time when we would typically be inundated with commercials about getting our Registered Retirement Savings Plan (RRSP) contributions in before the March 1st deadline. I am not watching the television airspace enough to know whether or not advertising has gone up or down, but there does seem to be a waning of urgency.
Part of the answer may stem from the fact that Canadians figured out that it made more sense to contribute over the course of the tax year and avoid the deadline crunch. That would indeed be a positive development as the best practice has always been to contribute early, or at least on a monthly basis, rather than wait for the deadline. I do wonder though whether some believe that RRSPs are not worthwhile, either because they have not sat down and examined the benefits, or because they have heard from someone that there is a disadvantage to investing in an RRSP. Unfortunately, some decisions being made today with respect to RRSPs and other registered accounts are based more hearsay versus fact.
Canadians have seen their investing choices multiply over the decades, both in terms of products and services, and types of accounts. Before the days of Diefenbaker, the only way to invest was to either have a trading account or simply buy stock certificates and bonds, and then stash them away somewhere.
In 1957, the RRSP was born and gave individuals a way of creating their own ‘personal 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 savings account 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 over and above their Canada (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 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 and some that already have one have even told me they cannot wait to draw all the money out before they retire. First, 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. In other words, the tax benefit from contribution deductions may not be any different than the tax payable when those funds come out down the road. Still, Canadians that find themselves in this situation form a very small minority, and a financial plan could help them understand their future after-tax income from an RRSP.
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 is now shortened. Canada does not have an estate tax (yet), but Ottawa does have a stealth one for those who did the right thing by investing in their RRSP yet passed 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 if there may be advantages to making periodic withdrawals from an RRSP.
RESPs
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 and only the payments that come out to the beneficiary are taxed and, in their hands, most likely at a time when their marginal tax rate is extremely low (or zero, if they have no other income). Sometimes I will hear people say that they shouldn’t open an RESP for their child or grandchild because if they don’t pursue a post-secondary education, the RESP will be closed, and they will be responsible for the tax owing. Keep in mind that a qualifying post-secondary education is not limited to just college or university. Trades, from carpentry and trucking to hair styling would also apply.
Okay, let’s assume the beneficiary doesn’t continue their education, cuts their time in school 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 only thing that is going to hit the tax bottom line for the holder of the account is income and growth that has been generated in the RESP. Keep in mind that there is an additional 20% penalty applied on the return of accumulated income. As for the contributed capital, it comes out tax free and the grants returned to the government.
It’s entirely possible that this happens, but where were those contributions going to be invested if not in an RESP? If it were in a non-registered account, the income would have been taxed at the holder’s marginal rate each year. Rather than focus on the worse-case scenarios of what happens when an RESP is closed, I suggest parents and grandparents look at the options and strategies of how to deal with this if and when that day arrives.
First, if there are multiple children in the same family, you may consider a family RESP rather than individual ones. If one child does not attend school or does not use his or her contributions, grants and income, the other child (children) in the plan can. If there is another beneficiary connected by blood and is under the age of 21, he or she can be added to the RESP.
Second, the government has a rule that in the first 13 weeks of a beneficiary’s education, the maximum that can be taken out of an RESP in the form of an Educational Assistance Payment (EAP) is the lesser of $5,000 or the expenses incurred in those 13 weeks. An EAP will include grants and accumulated income on contributions. After the 13 weeks, however, there is no limit on how much EAP can be taken out. When a payment is made, the subscriber/holder of the RESP indicates from which category the funds are coming from – contributions, grants or accumulated income. After those first 13 weeks, if you work on drawing down grants and income, the odds of getting stuck with a tax bill on early closure are minimized.
Third, educational expenses are not limited to just tuition and books. The residence charges, rent, food and travel costs. When we create financial plans for parents and grandparents and look at what a reasonable annual total cost would be for a student, we typically price in something close to $20,000. Considering that the maximum lifetime contribution limit per child is $50,000 and the lifetime government grant maximum is $7,200, it is unlikely that an RESP would have a considerable amount left over. The above chart shows a hypothetical example of an individual RESP with annual contributions of $2,500 starting in the first year of the child’s life and an annual investment return of 4%. By age 20, the RESP is just under $90,000. At $20,000 per year in costs, this would be adequate but $50,000 of that would be contributions. The remaining $40,000 would be made up of income and grants and would likely be used up by the end of school. Also, the $20,000 assumption we make today is based on current prices. I believe most children and grandchildren will likely pursue post-secondary 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, there is no such thing as a one-size-fits-all registered account strategy. Are there individuals and situations where an RRSP or RESP may not be beneficial? Of course, but before you make a decision based on general advice, do your research and sit down with an advisor to review your unique situation.
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These are the personal opinions of Andrew Pyle and the Pyle Group and may not necessarily reflect those of CIBC World Markets Inc.