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Hurting your retirement plan

The first impact of making early withdrawals is obviously that it will affect your retirement plan later on. If you leave your $15,000 in your RRSP account for 20 years at 7%, you would get $58,000. This represents $39,000 in today’s dollar (considering a 2% inflation rate). Therefore, taking $15,000 out of your RRSP account today means losing $24,000 if you plan to retire in 20 years.

Getting taxed right away

Whenever you withdraw money from an RRSP account, the financial institution will take a provision for taxes before giving your money. It is usually around 21%. Therefore, by taking 15k, you will only get $11,850. In addition to that, you will have to add 15K to your year end income when you fill in your tax report. Hence you will end up paying more taxes if your marginal tax rate is over 21% (which it probably is!).

You cannot put this money back in your RRSP account

Another severe consequence of withdrawing from your RRSP’s is that you cannot put this money back in. You are allowed to contribute a certain amount per year according to your income and once it is done, you cannot contribute again in order to “reimburse your RRSP account”. This means that a part of your investment may not be tax sheltered at one point in time.

Ways to get around this

Fortunately for us, there are two programs that allow us to withdraw money from our RRSP without getting taxed and without burning our contribution room. With the Home Buyer Plan (HBP) and the school plan, you are allowed to withdraw a certain amount of money (20K per eligible person for the HBP) and you benefit from a certain period of time to put it back into your RRSP account without paying taxes.

The only thing that you still have to consider in this situation is that you will still hurt your retirement plan. Sometimes it worth it, sometimes you can find other solutions for your money problems. I personally withdraw money from my RRSP without the HBP plan (it was for my second property) but it allowed me much more flexibility for my mortgage. When we talk about finance, it is not always black and white.

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Option #1: Full RRSP contribution

If Peter would to invest $300 a month over a period of 30 years, he would end up with $450,088. Over that period, we would also receive the sum of $1440 in tax return every year. If he would to invest this sum in a non-registered account, he would create an additional $176,178. However, Peter must keep in mind that he will have to pay taxes on the 450K in RRSP at the time of withdrawal. The marginal tax rate will be much lower on his non-registered investment.

Option #2: RRSP contribution plus an investment loan

At a borrowing rate of 7%, Peter would be able to borrow 30K to invest and his monthly payment (interest only) would be of $175 per month. Therefore, he would still get $125 to invest into his RRSP each year. This strategy would bring $301,879 in non-registered investments (including the 30K loan) and $187,536 in RRSP. This brings us to a total of $459,416 once we pay the investment loan. In Canada, the interest paid on an investment loan is tax deductible, therefore, Peter would receive again the same $1,440 that could be invested the same way as option #1. You may think that the whole strategy doesn’t really worth it as it creates only an additional 9K. However, you have to take into consideration that you have $301K sitting into a non-registered account.

Option #3: Registered and non-registered contribution

If Peter doesn’t believe in leverage strategies and still wants non-registered investment, he could invest $175 per month into a non-registered account and $125 into his RRSP. This would give him $450,088 but with much less tax return per year ($600 instead of $1440).

I would like to get back to option #1 and #2 one last time. Imagine that Peter’s marginal tax rate on his RRSP withdrawal his still 40% and 25% (capital gains, dividend, interest income mixed together) on his non-registered investment. If he would to cash in all his investment in one shot, the option #1 would give him $402,186 (450K*60% + 176K*75%) while option #2 would give him $448,565 ((301K-30K)*75% + 176K*75% + 187K*60%). Therefore, a small 30K investment loan would increase your net investment by 45K. This is the magic behind all the different ways of using your cash flow!

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We are now February 1^st and you have only a month left to contribute to your RRSP. But simply putting money aside in a RRSP account will only do so much. In fact, there are some basic strategies that could make your retirement portfolio much bigger. These strategies can be applied by anybody without much financial background of heavy calculation.

Reinvest your tax return into your RRSP

Many people do it already but I wanted to point the power of compound interest of this strategy. Let’s say that you make 75K a year and you are taxed at 40%. If you make a contribution of 5K per year for the next 25 years, your portfolio would worth $394,772 with an 8% return.

Over this period of time, you will receive $2,000 in tax return every year. If you invest this amount of money over 24 years (you get your tax return only after the 1^st year of contribution). This would equal to another $144,211 in your portfolio for a total of $538,983 in today’s dollar.

In addition to that, you will also receive an addition tax return on that extra 2K contribution you are making after the first year. This tax return equal $800. You can invest this amount as well in your RRSP over the next 23 years in order to get an additional $52,611. at this point, your $125,000 overall contribution (5K * 25 years) would give you $591,595. So by investing your tax return from your RRSP contributions, you will get $196,823 more in your portfolio.

If you want to make the exact calculation I suggest you go on the Ernst & Young Tax Calculator to get your marginal tax rate. Then, you can use any investment calculators from bank’s website or even better, bring your numbers to your banker and make him do the math!

Take a deferred payment RRSP loan

We will keep the same numbers from our previous example in order to demonstrate the power of taking a deferred payment RRSP loan. In financial planning, they say that RRSP loans are good as long as you are able to pay them off within two years. An interesting technique is to calculate your tax return according to your RRSP contribution and to make a loan in that amount.

In order to not affect your cash flow, you can take a RRSP loan in January of 2K and defer your first payment in six months. Therefore, you will not have to make your first payment before you get your tax return. In addition to that, your tax return will be of $2,800 instead of $2000 because your overall contribution for the first year will be 7K compared to 5K without the RRSP loan.

In our calculation, this accelerates the additional investment by 1 year in term of contribution. Therefore, you would get a total of $610,365 in your RRSP account after 25 years. However, you would have to pay interest on your 6 months RRSP loan where you don’t make any payment until you get your tax return. At a 7% interest rate on 2K over 6 months, this represents $70 per year or $1,750 for the full 25 years. However, you find yourself richer of $17,020!

You can easily get your tax refund from Ernst & Young’s website or then again, make your banker does some maths to make you richer. After all, it’s his job!

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