Don’t Let Your RRSP Get Too Big Too Late

RRSP accounts are a great way to save money for retirement. A little less great than the TFSA for more people, but still great nonetheless. As my previous posts have made clear, I love using RRSPs to fund periods of low income in your typical working life: childcare, a sabbatical, education upgrading, job loss, and so on.

These working-life withdrawals would obviously make dents in your RRSP value and eat into your total return potential. This is because compounding interest is a truly powerful force. At 6% annual return, your money doubles every 12 years without any new contributions. $10,000 today grows into $80,000 thirty-five years from now.

Clearly if you withdraw $40,000 from RRSPs in your late 20s to help you stay at home with the kids, you are missing out on a potential $300,000+ at retirement. But I want to tell you it doesn't matter.

As long as you are watching your spending always, withdraw only at low tax rates, and you continue to contribute to your TFSA accounts meeting your retirement math numbers, you will be on track for retirement.

The Big Tax RRIF Off

RRSP:  Registered Retirement Savings Plan
RRIF:  Registered Retirement Income Fund

Remember how I keep telling you to reinvest that RRSP tax refund because it's just a temporary loan? Well, like the big bad wolf, when you're old the government comes back again to huff and puff and blow your RRSP down—collecting their share of taxes due in the process.

The year you turn 71 you must convert your RRSP accounts into a RRIF account. They're basically the same thing except you can't contribute to the RRIF and you have to withdraw a mandatory minimum percentage of your account value at the start of each year. That percentage increases yearly.

At 71, you must withdraw 5.28% of your portfolio value on January 1. At 75 it's up to 5.82%. At 80 years old it's up to 6.82%. At 90 it's 11.92%. You will notice this is way higher than the 20x Rule withdrawal rate of 5%. That's because the government wants you to whittle down that account as fast as possible so they collect their taxes.

Calling this a RRIF Off is a bit of a stretch. Keep in mind this was a tax liability waiting to happen all along—you happily collected the tax refund each April for years. But it's important to know the tax rules so you can make sure you're not blindsided by massive mandatory withdrawals in your later years.

Limit the Size of Your RRSP

The first way to avoid RRIF tax nightmares is to limit the size of your RRSPs as you get into your 60s. You can easily do this by simply contributing less in your working years; contribute to the TFSA first instead!

If you target a RRSP/RRIF income of say $30,000 each when you turn 65, you only need to save about $325 a month per RRSP account starting at 30 years old (one for you, one for your partner). Comparing that income expectation to your RRSP value, you will both be well into your 80s before mandatory minimum withdrawals start forcing you to withdraw more than you need.

Better still, just max your TFSAs first and save the balance in your RRSP. You can almost never go wrong with this strategy. TFSA contributions are currently capped at $5,500 per year ($458 monthly). If you are single and have a $750 per month savings goal, fill the TFSA and make the remaining $292 monthly contribution to your RRSP.

If you start this at 30 years old and work till 65, you will not only have a fat $652,000 TFSA that generates $23,400 annually tax-free, you will also have a $416,000 RRSP account from which you can pull $30,000 per year for 30 years.

Withdrawal Strategies

Using the above example, your total withdrawal amount at 20x Rule is $53,400 for these accounts. However, for tax reasons you will start withdrawals at 7.2% from the smaller RRSP account to try chew it down first while withdrawing just 3.6% from your TFSA allowing some more growth there.

This helps significantly reduce your RRSP account value by the time you start getting hit by bigger than necessary RRIF withdrawals. Your tax rate on a $30,000 RRSP/RRIF withdrawal will be at your lowest marginal rates (generally around 20% blended), while your TFSA withdrawals are neither reportable nor taxable.

Another tactic is early retirement. Done correctly, you can really game the tax system this way.

Keep in mind, our nation's tax system is designed to soak mid-to-higher income salaried people who spend lots and then go after these same folks again in retirement with the RRIF.

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