Unsure of the best way to plan for your retirement? Registered Retirement Savings Plans (RRSPs) are one of the most popular retirement savings plans in Canada.
In fact, according to Statistics Canada, it remains one of the three “pillars” of Canadians’ retirement income systems, with RRSPs accounting for 29 per cent of the share of elderly Canadians’ total income, according to latest available data from 2020.
But while RRSPs have some clear benefits, they also come with pitfalls that can affect your long-term financial health.
Below, I’ll briefly explain how RRSPs work and outline some of the drawbacks of using an RRSP as your sole retirement plan. Then, I’ll share some viable alternatives to help you better prepare for retirement!
How do RRSPs work?
The RRSP was introduced by the government in 1957 to bridge the gap between everyday workers and those who already enjoyed the tax benefits of registered retirement pension plans.
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Canadian workers in all lines of work could open an RRSP with a bank and start saving for their retirement, taking advantage of tax-deductible contributions and tax-deferred growth -- even if they didn’t work for an employer with a pension plan.
The introduction of the RRSP also offered tax deductions to businesses willing to match a percentage of their employees’ contributions, resulting in a win-win for both parties.
Here are the basics of how an RRSP works:
- Canadians are allowed to contribute an annual maximum to their RRSP account
- The RRSP can be used as a traditional savings account or can be used to hold investments, such as stocks, bonds, ETFs, GICs, and more
- Contributions made to your RRSP are tax-deferred, meaning they lower your immediate income tax
- Growth in your RRSP is also deferred, meaning you won’t pay taxes until you begin to withdraw from the account post-retirement
Key disadvantages of RRSPs
At inception, the RRSP was likely the best solution for retirement savings as there were very few alternatives. Comparing it to the other options available to Canadians today, though, there are some disadvantages.
Tax implications
While contributions to an RRSP are tax-deductible, and investments grow tax-deferred, the withdrawals during retirement are fully taxable.
This means that if you have a high income in retirement, you could end up paying a large portion of it to taxes.
Restricted withdrawals
One of the significant disadvantages of RRSPs is the penalty for early withdrawals. If you withdraw funds before retirement, you will need to pay a withholding tax on the amount you take out. You’ll also permanently lose the contribution room in the future.
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This restricts access to your savings in case of financial emergencies. This is also why I recommend creating an emergency savings account, so you have immediate access to your money when life throws you a curveball.
Impact on government benefits
Withdrawals from an RRSP during retirement can affect your eligibility for government benefits such as Old Age Security (OAS) and the Guaranteed Income Supplement (GIS).
The additional income from RRSP withdrawals can reduce the amount of these benefits you receive, impacting your overall retirement income.
Alternatives to help you save for retirement
I’m not here to tell you that RRSPs are all bad. In most cases, they are still a great retirement tool to take advantage of, especially if you work for an employer that matches some of your contributions, as it’s basically free money.
However, there are a few alternatives to consider using in addition to an RRSP to help you save for retirement.
Maximize TFSA contributions
The Tax-Free Savings Account (TFSA) is easily one of the best savings and investment vehicles available. These accounts can be used to hold investments like stocks, bonds, ETFs, and more.
The best part is that any growth in these accounts is 100 per cent tax-free, and you can withdraw profits without paying taxes. This isn’t the case with an RRSP.
Use your FHSA
The First Home Savings Account (FHSA) can be a valuable retirement savings tool, especially if you decide not to buy a home. Like an RRSP, contributions are tax-deductible, and the funds grow tax-free.
If you don't use the FHSA for a home purchase in 15 years, you can transfer the funds to an RRSP or RRIF without affecting your existing RRSP contribution room, which allows you to maximize your retirement savings with additional tax-advantaged space.
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The FHSA is a very new account, but the flexibility it provides makes it a very interesting option for financial planning.
Permanent life insurance
Certain types of permanent life insurance, such as whole life or universal life, include a savings component that grows over time. This cash value can be accessed through loans or withdrawals, potentially offering a source of retirement income.
While these policies are more complex and typically more expensive than term life insurance, they provide both a death benefit and a tax-advantaged savings component. However, these products are complex and come with higher fees, so they should be considered carefully, often as part of a broader estate planning strategy.
What’s the best way to save for retirement?
If you aren’t sure about which to contribute first, consider starting by maximizing your TFSA contributions and then put any other extra funds into an RRSP. This will help diversify your retirement funds, and TFSA withdrawals won’t affect your future government benefits like OAS or GIS, making it a more flexible option than the RRSP.
Keep on reading for some great tips on how to get the most out of your TFSA.
Christopher Liew is a CFA Charterholder and former financial advisor. He writes personal finance tips for thousands of daily Canadian readers on Blueprint Financial.
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