Saving for A Baby: The RRSP Baby Fund

Last week we learned that RRSPs are a great tool for retirement saving in many circumstances. However, retirement isn't the only smart way to use RRSPs. They can also be used very effectively for income splitting and tax saving when planning a family. For many Canadians a traditional life cycle goes something like this. Go to college, get a job, find your true love, spend some time together, start a family, struggle financially, get older, save some money, etc.

Talking to my friends, one of the hardest decisions for moms is the decision of going back to work after having a baby. Like it or not, finances are a key factor in this decision and may essentially "force" mom or dad to go back to work. If this sounds like you, there's a great way to save money on taxes and set up a tax-efficient income stream for the stay-at-home parent. I'll call it the RRSP Baby Fund and it works for moderate to high income couples—with RRSP accounts. (The higher the income the bigger the benefit.)

Using Spousal RRSPs for a Baby Fund

We know standard RRSPs are tax deferral accounts where the contributor is able to deduct contributions from their taxes now, but must pay income tax on withdrawals later. Spousal RRSPs are similar, but contributions made by you are designated to benefit your spouse (or common-law partner). You claim the deduction, get the tax refund, and lose the "RRSP room", but your spouse gets to withdraw the money and pay taxes at their income level later.

Withdrawals from a Spousal RRSP are reported on your spouse's tax return *if no contributions were made to the Spousal RRSP account in the tax year of the withdrawal and the two years preceding the withdrawal*. If you have time to plan in advance, a couple could shift income from high earning working years to those low earning childcare years and from one spouse to the other.

Take Note: If you're using this strategy it's important to reduce your portfolio volatility because your investment timeline is shorter. You should have no more than 50% stocks in your account.

Example Case Study

Doug and Kaylee are 24 year old college sweethearts in Ontario. They graduated last year, are in a common-law relationship, and both found good jobs that pay $60,000. They can each contribute a maximum $10,800 (18% of income) to RRSPs. They are both currently in the 29.65% tax bracket so for every $100 dollars they contribute to RRSPs, they reduce their taxes by $29.65. Their plan is to have at least 2 children, have their first when they turn 30, and Kaylee wants to take leave from work until their second child goes to Kindergarten when she's 37. They heard about the RRSP Baby Fund so they put it to work.

Kaylee will get 1 year of EI maternity leave, so Doug can only contribute for 4 years to keep the 3 year buffer (so the Spousal RRSP withdrawal gets claimed on Kaylee's return, not his). Kaylee maxes out her RRSP contribution each year for the whole period; she's contributing to her personal RRSP so she doesn't need to wait to make withdrawals and can use any excess money for retirement.

By age 30, Kaylee will have $74,230 in her personal RRSP if she contributes $900/month for 6 years in a more cautious portfolio returning 4.5%. If Doug contributes $900/month for 4 years to a Spousal RRSP benefitting Kaylee and then let's it ride with no new contributions, the Spousal RRSP will have $51,675. They won't make withdrawals from any account during the first year of Baby 1 because Kaylee will get EI, so the accounts grow to $77,570 (Kaylee RRSP) and $54,000 (Spousal RRSP). Because there were no contributions to any Spousal RRSP for 3 years, Kaylee can start claiming withdrawals from the Spousal RRSP as her income when she turns 31 and needs to make the money last 6 years until she goes back to work.

Annual Spousal RRSP withdrawals will be $10,450 each year to deplete the account and personal RRSP withdrawals will be a max of $15,040. Let's assume they need to make the max withdrawals to pay for all those diapers and formula—Kaylee's taxable income is $25,490. Her net income after the Child Benefit maxes out at $27,822 after the second child.

The tax rate on Kaylee's RRSP withdrawals is ~14%. Big difference from the 29.65% tax refund on contributions!

Here's a visual of this strategy:


The Alternative

What if they had just put the money in a regular investment account (normal baby fund)? Their contributions would be reduced to $7,600 per year each because they wouldn't receive the $3,200 tax refund. All other factors identical, by the time Kaylee needed the money at 31 years old, the account would be worth $92,540. This will allow max account withdrawals of just $17,940 per year if they want to money to last 6 years.

Although the RRSP contributions were made on moderate $60,000 incomes, they are way better off using the RRSP Baby Fund method because the tax rate on withdrawals is so low.

Smart tax planning strategies like this could mean the difference between staying home with the kids, or having to go to work and putting the kids in a germy daycare.

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What’s 2.5% Costing You?

Two point five percent. That's about the average hidden Management Expense Ratio (manager fee + fund expenses) of a typical mutual fund in Canada currently being sold to you by the big banks, insurance companies, and investment firms. Of that, the salesperson ("advisor") gets a handy commission of course. But, how much is it costing you?

Mutual funds are the go-to investment products sold by "advisors" because they carry hefty embedded commissions. Basically the "advisor" wants to get paid first.

With some exceptions you generally get suckered in like this. You get referred by someone to go see a certain advisor (he's great, he made me $xxx last year). The "advisor" briefly discusses your financial situation with you and goes over some paperwork. A few weeks later, he calls you in and presents a plan. There's some fancy talk about tax efficiency, out-performance, diversification, professional management, risk mitigation, personalized bla-bla-bla...

Next, he recommends an investment product or two that you should purchase because they're the best for your situation. These products are mutual funds and often the "advisor" all but suggests they cost you nothing. The truth is they don't bill you directly; even the "advisor's" time and services appear free. But even you know the guy's new BMW, shiny suit, and smashing receptionist don't come as a result of "free" services. So how does he make money?

Sales Commissions

There are two ways the "advisor" gets paid and it's all kind of swept away in a smaze of silky words and stacks of paper. First, when he sells you into a mutual fund product, he collects a one-time sales fee on each purchase. Often between 3-5% of your up-front investment. Then he gets a piece of that 2.5% hidden MER each year, usually 0.5-1.0%, called the trailer fee for as long as you're invested in that fund.

A bit of simple math tells us the "advisor" stands to collect as much as $5,000 in year one and $1,000 every year following for every $100,000 you invest with him. He's not paid directly by you, but for every $100,000 you invest you indirectly pay $2,500 in fees from which he receives a healthy kickback from the fund company.

The 2.5% MER embedded into your mutual fund actually comes straight out of your returns every year. Pick just about any mutual fund from a major provider that's been in play for at least 3 years and compare to the true index benchmark (not the company's Frankenbenchmark). Most of the time you will find the mutual fund under-performed the comparable index ETF by a few percent each year. Sometimes it's much more.

Consider a popular blue company's US Large Cap Series A fund which returned 16.68% annually over the last five years; at the same time Horizon's S&P 500 Index ETF returned 20.83%. The blue company's International Equity Series A fund returned a pathetic 2.67% annually over the last three years; iShares Canada's Core MSCI EAFE Index ETF returned 6.39%. These are just examples from one major fund company, but the story plays itself over and over across the industry.

Mutual funds with high fees cannot beat low-fee index ETFs over long time periods—it's mathematically impossible. In fact studies show less than 1% of portfolio managers can outperform their comparable index over a long period of time. They may outperform for a year or two here and there, but that's it. If your "advisor" is promising you high performance to justify the fees he'll hardly mention—run!

The Results

This frequent underperformance isn't necessarily the result of bad stock picking by fund managers, it's mostly due to the fees that drag on portfolio performance during up years and down years. Fees used to pay for your guy's car, suit, glass office, and the receptionist. It costs you a wack of money.

An index ETF charges about 0.20% MER compared to a mutual fund's 2.5% MER. That 2.3% drag difference due to fees can make you seriously poor. In fact, a 2.3% additional fee cuts your total investor return by one-third over 25 years. No wonder millions of Canadians believe the only path to wealth is rental real estate!

Example Comparison

Dave invests in a Balanced Portfolio that returns 8% annually (not adjusting for inflation). He has $100,000 now and will invest $10,000 a year for 25 years. Dave's portfolio will be worth $1.4 million at the end of the 25 years.

Dave's friend Wendy invests the same amount of money with her "advisor" and gets a net return of 6% due to the higher fees. Wendy's portfolio will only be worth $975,000. Over the years the fund company will have quietly siphoned off $425,000 (of which your "advisor" received close to half). Not bad for a bi-annual meeting and some market update emails.

In Retirement

When you're retired the high mutual fund fees really hurt and greatly decrease your chance of success over a long retirement. Remember the 30x, 25x, 20x rule from last week? At a 5% withdrawal rate (20x), you are pulling in $50,000 a year. Add on a 2.5% MER and the true deduction off your portfolio performance is actually 7.5% or $75,000 a year. That silent fee comes off during up years and down years as the fee is charged regardless of the portfolio performance.

On a baseline growth portfolio holding 80% stocks and 20% bonds, your real historical success rate during a 25 year retirement is just 52% when paying a 2.5% MER. Do you want to leave the probability of success on your hard-earned retirement up to a coin toss?

If you want an advisor to help with your portfolio and taxes, hire a pay-for-service advisor. Trust me, you can buy a lot of great advice from accountants and financial planners for way less than $25,000 a year. But it really pays to understand your investments, self-manage your portfolio, and learn the basics of taxes so you can save money on those fees through your whole financial journey.

*"Advisor" intentionally in brackets as many selling these 2.5% funds are really just barely qualified financial product salespeople.

Comments & Questions

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