Proper Ways to Use RRSPs

With the March 1, 2018 deadline for RRSP contributions (attributable to 2017 income) fast approaching, let's do a quick review of who should use RRSPs and how to maximize their tax advantages for different purposes.

RRSP Basics

First, it's important to understand what RRSPs are and how they work. An RRSP is a special type of savings account that carries certain tax advantages. RRSP accounts are different from TFSA accounts and non-registered (Cash/Margin) accounts.

You must look at your income tax situation to determine if RRSP accounts should be part of your savings plan. Contributions to your RRSP are deducted off your taxable income. This reduces your income tax owing on your income.

On the other hand, withdrawals from RRSP accounts are taxed as regular income. Any gains or losses on investments that remain in your RRSP account are not reported on your income taxes.

Since RRSPs can be quite lucrative—particularly for higher income individuals—the government has decided to cap contributions at 18% of pre-tax income to a maximum of $26,010 in 2017 (don't want people saving too much I guess). Hopefully one day the government will reform and simplify our tax system so we don't need to deal with special accounts and this limit nonsense; I'm not holding my breath!

If you earned $100,000 in 2017 and contributed the maximum $18,000 to your RRSP, you would only be required to pay income tax on $82,000 for the year instead of the whole $100,000. However, years down the road when you withdraw that $18,000 plus the investment gains earned on that money, you will claim that as regular income and pay tax on it at that time.

In a nutshell, RRSPs do not always save you tax, but they always defer taxes to a later time. To meaningfully save tax, you must contribute to your RRSP accounts when you are in a high tax bracket (earn a high income) and withdraw money from your RRSPs only in years where you are in a low tax bracket (earn a low income).

Good Scenarios for Using RRSPs

I think it’s generally good practice to always try put money into your RRSP—especially if you earn income that’s higher than the second tax bracket (more than $90,000).

For most people this means they should fill their TFSA first and their RRSP accounts after that. (There are some exceptions to this for high spenders or very low earners.)

Standard Retirement Savings

RRSPs are a decent tool for retirement savings. In retirement, you almost invariably earn less taxable income than when you are working. This is because your spending is likely to be lower and you only need to withdraw the funds you require to pay your daily expenses. You no longer need to pay for savings, or work-related expenses. Researchers estimate Canadians spend 20-40% less money in retirement compared to when they are working.

You can also split RRSP income with your spouse, further assisting you in staying in the lower tax brackets. You can do this with Spousal RRSPs or under the current pension income splitting rules when you’ve converted your RRSP to a RRIF.

At some point you must convert your RRSP to a RRIF (age 71 at the latest). After the conversion to a RRIF, you can no longer contribute to the account and you are required to make minimum taxable withdrawals from your account each year. These withdrawals grow year after year and can put individuals with very large RRSP/RRIF accounts into very high tax brackets. It could also result in claw-backs of seniors benefits ranging from Old Age Security to prescription benefits.

If you are using RRSPs for retirement savings, be careful you don’t let your RRSP accounts become too big! Even $1 million per person is probably too big for most people.

Sabbaticals / Stay-at-home Parenting

RRSPs are a great tool to save for sabbaticals. In our society, especially the younger generations, it is increasingly unlikely that you will work the same job at the same company for your entire working career. Taking sabbaticals between career changes is a growing trend.

This is for a few reasons: people are finally doing something to combat boredom at work, job markets and solo entrepreneurship have been relatively robust, the traditional loyal employer-employee relationship is breaking down, and employee benefits are slowly being cut which reduces the golden handcuff effect.

More and more people are refreshing themselves and their careers by taking sabbaticals. It generally means taking a year or two off work to reset your life. On sabbaticals people might travel, go back to school, develop a plan to start a business, spend time with kids, or fulfill any other passion.

Naturally, during a sabbatical, you are probably not going to earn much income. For this reason it’s a great time to withdraw some money from your RRSP at very low tax rates.

If you are planning a sabbatical in your future, save for it by contributing to an RRSP now when you are earning a higher income and use the tax savings to pay for part of your sabbatical.

This same principle applies to stay-at-home parenting. If you are planning on having kids and want to stay at home for a few years to raise them, you can use RRSPs and Spousal RRSPs to both save now while you are working. Then, the stay-at-home spouse (and Spousal RRSP beneficiary) can deplete the RRSP accounts at low tax rates while they are home. I talk more about that in this post.

Adult Education

Along the theme of sabbaticals, RRSPs are also fantastic tools to save for further education. You can use your RRSP to pay for school expenses and living expenses while you are going to school. If you are going to school on a full-time basis, you can also take advantage of the Lifelong Learning Plan (LLP).

The LLP lets you “borrow” up to $10,000 per year, or $20,000 total, from your RRSP to pay for your education. While you must be enrolled in school full-time, the borrowing use is not limited just to tuition or related direct education expenses.

The LLP is great because you do not pay any taxes on the withdrawals! The only catch is that you must pay money back into your RRSP once your education is finished. This repayment is typically done by paying back 1/10th of your total LLP borrowing over 10 years.

If you need more than $10,000 a year while you are in school, you simply make a standard RRSP withdrawal and pay tax on it. Again, your tax rates are likely to be very low if you’re going to school full-time so it's a great way to use tax savings to fund your education costs.

Home Downpayment

When it makes sense for you to buy a house, you can use your RRSP to fund part of the downpayment for the house purchase. The Home Buyers Plan (HBP) let’s new home buyers “borrow” money from their RRSP as a downpayment if they have not owned a house in the prior four years.

The HBP limits your withdrawal to $25,000. However, as with the LLP, your withdrawal is not taxable. This is an excellent way to get money tax-free out of your RRSP and use before-tax money to pay for your house.

HBP borrowing from your RRSP must be repaid over 15 years, starting the second year after you pulled the funds out of the RRSP.

Early Retirement Savings

The RRSP is a fantastic savings account to use if you plan to retire early. Generally people can retire early only because they spend a lot less than they earn. This often means above average income combined with below average spending (a perfect combination for tax arbitrage).

Since RRSP contributions save you money on taxes during your higher-tax income earning years, you can get a big boost by putting as much money as you can into your RRSP when you are employed.

The size issue of having a large RRSP is not a problem for early retirees. If you retire at 50 years old instead of 65 years old, you have given yourself an extra 15 years to slowly whittle down your RRSP before those mandatory RRIF withdrawals kick in.

Since your expenses are likely to be low, your RRSP withdrawals should be at low tax rates. RRSPs are much better than TFSAs if you are contributing at a 40%+ tax rate and withdrawing money at a 15% tax rate.

RRSP Pointers

  • Don’t be afraid to invest aggressively, within the limits of your risk tolerance, in your RRSP accounts. Contrary to some popular misconceptions, RRSPs are not just for bonds or low-growth investments. Total net worth is what counts!
  • Don’t ignore RRSPs because of bad information. RRSPs are much better than saving in a non-registered investment account for the vast majority of Canadians. Chances are you are in that majority.
  • If you make RRSP contributions throughout the year, use a form T1213 to get less tax deducted off your paycheques now and increase your savings all year.
  • Always invest your tax refund! If you don’t invest the tax refund from RRSP contributions, you are taking away the benefit of saving in an RRSP. Tax refunds should be viewed as a temporary loan from the government that you must pay back at some point.
  • Take a serious look at Spousal RRSPs. While current income splitting rules allow you to split any RRIF withdrawals with your spouse when you are a senior, it is a rule that is easily changed. If you earn substantially more than your spouse, or one of you has a defined benefit pension, Spousal RRSPs could be your best retirement savings option.
  • As with all investment accounts, choose a low-cost option like ETFs in a self-directed RRSP account. Managed RRSP accounts and RRSPs with the bank or life insurance company typically come with high fees in their products. These high fees can severely reduce your return on investments over your investment lifetime. You should never, ever pay more than 1.0% of your investment asset value in total fees!

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Leveraged Portfolios

The more I research and back-test different types of portfolios, the more certain I have become that using leverage over long periods of time with adequate protection for your situation is one of the best ways to invest. Even if you are not looking for long-term alpha (performance that beats the index), leveraged strategies can also offer really nice downside protection and add stability to your portfolio.

Leverage is best used by more advanced investors with larger accounts and more experience. It requires a lot of discipline to introduce leverage and maintain your portfolio without blowing it up. You must be able to invest with logic, ignoring our natural desire to get greedy during bull markets and fearful in bear markets.

The Strategy Idea

The protection element will form the larger part of your portfolio equity. You should never open up your portfolio to a loss greater than 50% of your equity.

Protection can be achieved with short-term bonds, T-bills, broad bonds, or some other type of bond strategy. More advanced investors might even introduce a bond barbell with tail-risk approach. This large bond portion will generate a steady 1-3% annual inflation-adjusted return over time.

The bonds will consist of 50% to 80% of your portfolio equity. The percentage of your portfolio that you put into bonds will depend on your risk tolerance. While 50% bonds might be appropriate for an aggressive saver with a high risk tolerance, 80% bonds is better for a retiree or more cautious investor.

Then, with the remaining portion of your portfolio equity (50% to 20%), you invest in a stock ETF and leverage it up 2:1 or even 3:1. You take advantage of bull markets by letting the leveraged stock portion propel your portfolio ahead. But during down markets, you are prepared to let the stock portion go down to nothing.

When you buy your stock ETF with leverage, you will always put in a limit stop-loss order. The price would be set at the number where your stock portfolio drops to nothing. This is 50% of the purchase price where you are leveraged 2:1, or 67% of the purchase price where your portfolio is leveraged 3:1. You could also set it as a trailing limit stop-loss. This means your stop price will go up as your stock ETF increases in price.

Historical Results

Here is a graph of the estimated historical results of this strategy going back to 1970. To keep the back-test simple, I used U.S. stocks (total return) and 1-year T-bills (yield averaged). The simulation based on re-balancing your portfolio at the beginning of every year.

Growth of $100 - Comparison of Leveraged Strategies (Log Chart). Source:, MSCI Inc., FRED (Federal Reserve Bank St. Louis)

Disclaimer: These are models, not realized investor returns. Past model returns do not translate to future real returns. No adjustments were made for taxes or transaction costs.

As you can see, all the leveraged portfolios significantly outperformed the basic U.S. stock index. Apart from the green line (50% bonds / 50% stocks leveraged 3:1) and red line (50% bonds / 50% stocks leveraged 2:1), all the portfolios were more stable than investing in stocks only.

Compound Annual Returns (1970–2017)

Blue (100% U.S. Stocks only):  10.57%
Red (50% 2:1 Stocks & 50% Bonds):  13.10%
Yellow (40% 2:1 Stocks & 60% Bonds):  11.72%
Green (50% 3:1 Stocks & 50% Bonds):  17.51%
Purple (40% 3:1 Stocks & 60% Bonds):  15.56%
Cyan (30% 3:1 Stocks & 70% Bonds):  13.30%

Worst Year (1970–2017)

Blue (100% U.S. Stocks only):  -37.14%
Red (50% 2:1 Stocks & 50% Bonds):  -36.32%
Yellow (40% 2:1 Stocks & 60% Bonds):  -28.73%
Green (50% 3:1 Stocks & 50% Bonds):  -49.19%
Purple (40% 3:1 Stocks & 60% Bonds):  -39.02%
Cyan (30% 3:1 Stocks & 70% Bonds):  -28.86%

The worst-case scenario for a leveraged portfolio of this type is a prolonged multi-year drawdown—particularly if there is no tail-risk hedge in place. For example, if you have stocks leveraged 3:1 in a 50/50 split and we have two years of back-to-back 33%+ drops in stocks, you could see your portfolio get cut in half twice (75% total drawdown from peak).

It’s also dangerous to re-balance too frequently, particularly during drawdown periods. Re-balancing once a year is a good number, every eighteen months is acceptable as well.

Leveraged ETFs or Leverage with Margin

Both leveraged ETFs or using margin to leverage up traditional ETFs are acceptable ways of implementing this strategy. There are pros and cons to both methods. Leveraged ETFs get a bad rap, but it's hard to know if that reputation is deserved or not. They've only existed since 2007 and their performance is pretty comparable to what one would expect.

I would probably use leveraged ETFs in a registered account and standard ETFs with margin in a non-registered account.

Leveraged ETFs Pros

  • Never goes down to $0/unit
  • No stop loss required
  • Outperforms in low-volatility markets
  • Easier to implement
  • Only way to use strategy in a registered account

Leveraged ETFs Cons

  • Higher hidden expenses (MER)
  • Potentially not as tax efficient in a margin account
  • Can track the index poorly in high volatility markets

Standard ETFs Leveraged with Margin Pros

  • More cost-effective ETFs
  • More choice in ETF providers
  • Great for margin account with low interest expenses
  • Better tracking of underlying index

Standard ETFs Leveraged with Margin Cons

  • Interest must be tax-deductible to manage costs
  • Requires a stop-loss mechanism
  • More management of accounts for taxes

Words of Caution

As with any strategy, it's important that you ensure your portfolio is set up appropriately for your risk tolerance. This differs for each individual. There is nothing more reckless than believing you can handle an aggressive strategy only to see yourself panic during even the smallest market downturns.

Periodic re-balancing is very important due to the leverage aspect. However, frequent re-balancing is actually harmful and will hurt your performance. It makes no sense to re-balance more than once per year. In a way, leveraged portfolios incentivize you not to play with your portfolio.

It’s important to understand you must treat each account like its own portfolio. You cannot put a leveraged stock ETF in your TFSA and your bonds in your RRSP for “tax efficiency”. Since the contributions to a registered account are limited, you will not be able to re-balance effectively. In the above example, you could easily see your TFSA go down to $0 with no way to fill it. That would be like starting your TFSA from square one again. All that potential of tax-free growth would be lost.

Using leverage in a portfolio is only for a more advanced investor who understands risk. This is because you must have the appropriate safeguards in place and manage them correctly. Safeguards include use of stop-losses, establishing an appropriate margin of safety, and completely understanding the strategy and how it will perform in up and down markets. Leverage can do significant harm to your wealth when you try to chase quick returns.

Improper use of leverage is the fastest way I know to become broke very quickly. This is called "blowing up your account". Even so-called professionals do this all the time. Leverage is why newspapers run sob-stories about former investment bankers flipping burgers at McD's after every big market correction. It happened in 1974, 1987, 1990, 1998, 2001, 2008, and will happen again.

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.