Retirement Planning

The saving years: Under age 40

Start saving early. Those are the three most important words in the retirement planning process. They may also be the most difficult to follow.

People under the age of 40 have many financial priorities, all of which may seem more important than an event that is perhaps 20 to 30 years in the future. There are cars to buy, mortgages to pay, families to be started and vacations to be taken. Maybe there will be something left for an RRSP contribution at the end of the year. If there is not, many younger Canadians say, “I’ll do it next year.”

From a financial perspective, however, time is precious. Every missed year of RRSP contributions when you are young can add up to thousands of lost dollars later.

Let’s look at a 25-year-old who can contribute $5,000 a year to an RRSP and see how much the plan would generate by age 65 at an average return of 6.5%. Then look at what happens with each year of delay (see Time is Precious box). Even a short postponement of 4 years would result in $212,675 of lost value.

Four tips for savingHere are a few things you should always do:

  1. Make saving a habit – When you are preparing a family budget, set aside a specific amount for your RRSP each month.
  2. Match savings to income –The more you earn, the more you will be able to contribute to an RRSP – and the more income you will need at retirement to maintain your standard of living. So whenever your salary increases, add a portion of the raise to your retirement budget.
  3. Contribute regularly – The easiest way to make sure your RRSP continues to grow is to set up an automatic monthly contribution plan.
  4. Make your maximum contribution – The more money you can shelter from taxes inside an RRSP, the faster your plan will grow. If at all possible, make your maximum allowable contribution every year.

Choosing the right strategy – Contributing to your RRSP is just part of building a solid retirement plan. You also need to give careful consideration to how the money is invested.

During your early years, you should focus on maximizing growth in your plan. Equity mutual funds, which invest in stocks, are an appropriate way to do this. Over the long term, stocks have historically outperformed all other types of investments. As well, when there is a market correction, you have plenty of time for your funds to recover.

By emphasizing equity funds when you’re young, you can take full advantage of that potential.

Building wealth: Age 40 to 60

The years have passed. Your life has evolved and changed. Now you are 40 or beyond. The mortgage is close to being paid off, your income is higher, and your debts are lower.

You are now moving from managing debt to building wealth. At this time in your life, it is important to put as much money as possible aside for the future, both inside and outside your RRSP. Tax planning for your retirement years also becomes an important priority.

Here are some things you should be looking at during this stage.

Maximize contributions – Ideally, you have been making your maximum allowable RRSP contributions all along. If you haven’t, now is the time to start.

You should also catch up on any unused carry-forward entitlements. If you did not make your full RRSP contribution in any year from 1991 on, you can make up the investment at any time.

Here’s a special tip. If you don’t have the cash to make your maximum RRSP contribution, consider borrowing the money. Special RRSP loans are available at very attractive interest rates.

Tax-saving strategies – From a taxation perspective, the worst situation is to have one spouse with very high income and the other with little or none after retirement. Dividing income more evenly usually produces a lower combined tax bill.

You can split RRIF income, for tax purposes, with your spouse if you are 65 or older. To create the flexibility to split income prior to 65, consider having the higher income spouse contribute to a spousal RRSP.

Tax-efficient investing – Capital gains and Canadian dividends are subject to a lower tax rate than other sources of income. Any income withdrawn from an RRSP is fully taxable at your top marginal tax rate. In keeping with your asset allocation plan, it makes tax sense to hold any interest-bearing investments inside your RRSP – since they are 100% taxable – and hold investments that produce Canadian dividends and capital gains outside your RRSP. Your Consultant can help you to create a tax-efficient investment plan that’s right for you.

Resist the temptation to dip into your RRSP – Usually, there is nothing to prevent you from accessing the investments in your RRSP before retirement. However, you should consider the consequences before you do so.

First of all, withdrawals are taxed at your marginal rate, and are subject to withholding tax of 10% to 30% at the time of withdrawal. Secondly, you cannot restore the contribution room. The amount that you can contribute to an RRSP in your lifetime is limited and a withdrawal erodes some of this potential.

The Home Buyer’s Plan and the Lifelong Learning Plan are two exceptions. They allow tax-free withdrawals with the ability to re-contribute. However, even in these plans there is no ability to replace the tax-deferred growth on your investment that was lost when you did the RRSP withdrawal.

Retirement years: Age 60 plus

Retirement allows you to enjoy the benefits of the years of careful planning and saving. Before you can put up your feet and relax, however, there are a few more things that need to be done.

First, you need to plan your retirement income. Should you set up a Retirement Income Fund (RIF) or buy an annuity? That’s the basic decision facing retirees who are deciding how they will convert their RRSP capital into income.

A RIF is a mirror image of an RRSP. An RRSP is designed to help you accumulate assets, while a RIF is designed to distribute those assets, under your direction, as retirement income. An annuity is a contract with a financial institution that provides you with regular income in exchange for a fixed sum of money.

Both options have advantages.

Don’t rush to convert – You can retain your RRSP until December 31 of the year in which you turn 71. If you do not need the income immediately, keep your RRSP intact for as long as possible after retirement. But make sure that you convert your RRSP to a RIF or annuity prior to the end of the year in which you turn 71.

Even if you make no further contributions, your plan will benefit from the extra years of tax-sheltered compounding. In fact, the greatest growth takes place in the final years of a plan.

Protection against inflation – Even at today’s modest levels, inflation can have a serious impact on purchasing power during your retirement. One way to protect yourself is to continue to include some growth assets (such as stocks and equity mutual funds) in your investment portfolio. This will make it possible for your asset base to increase in value over time, and provide a cushion against future cost-of-living increases.

This strategy can be used in an RRSP, a RIF and in your non-registered investment portfolio. However, it cannot be applied to assets that are used to purchase an annuity.