The Tax Trap

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Jason thinks he’s kinda rich. Not just for the townhouse in Oakville (mortgaged) or the Land Rover (leased) or the hot wife (not working), but mostly for his liquid assets. “Just like you keep on telling people,” he said to me after that last intimate event in Toronto, “balanced and diversified, making dividends and capital gains. All four hundred.”

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Well these days having $400,000 saved is no mean feat for a 46-year-old. Rich, it’s not. A decent start, it is. But Jason’s got a problem. It’s all registered money.

Sadly this is a common affliction, and before we hit that time of the year when every bank and mutual fund is yelling at you to ‘buy’ an RRSP, let’s drill into this for a few minutes. As I told Jason, he should stop stuffing money into his plan, redirect his energies and never again think of a retirement savings plan as something for retirement.

A quick summary: RRSPs are not products or things, but just tax shelters. You can put in them whatever you want, like stocks, funds, ETFs, bonds or cash. Each year you’re allowed to contribute up to 18% of your earned income, which includes salary or rental income, but not investment earnings or that wet T-shirt prize money. The 2012 max is almost $23,000.

You can also make a contribution without money, by shifting into an RRSP stuff you already own, such as a mutual fund or a pathetic GIC. That’s called a ‘contribution in kind’ and for selling yourself assets you already own, you’ll get a tax deduction.

In fact, that’s why most people contribute at all, to (as everybody says) ‘save taxes.’ The annual contribution can be deducted from your taxable income, which means the more money you earn the greater the benefit of doing this. What’s lost on many is the fact taxes are not being saved at all, but merely put off until a later time – when the consequences can be disastrous.

The other benefit of an RRSP is that the things you put inside there can grow in value, and the growth will not be taxed. Cool. But now that we have the TFSA, where the same tax-free compounding can take place, the clunker retirement plan – invented in the 1950s – is probably obsolete. At least when it comes to saving money for the wrinkly, sexless years.

First (as mentioned) taxes ‘saved’ today are payable later. Many people assume they’ll be in a drastically lower tax bracket when they retire than when they work, and therefore pay less tax by deferring it. That seldom works. For example, if you earn $80,000 and live in BC your marginal tax rate is 32%. But if your income plunges by half in retirement, and you’re squeaking by on $40,000, your tax rate’s still 23%.

But a bigger concern is that for anyone less than a decade away from post-work stupor, personal tax rates could actually be higher. After all, the federal government’s deficit has ballooned to a record $582 billion in the Harper years, while the federal deficit went from zero to $55 billion during the financial crisis, and still sits at $28 billion. That amount is added to the debt annually. The simplest way to deal with this? Raise taxes. Especially on ‘wealthy’ retirees who have fat RRSPs, which are conveniently registered with the government.

But RRSPs have more warts. If yours is full of stocks, ETFs or mutual funds that earn you dividends and capital gains, it’s a failing strategy. Sure, you can shelter the growth, but you’re squandering tax efficiencies. That’s because money received in the form of capital gains or dividends is taxed at about half what you pay on your salary. But all money taken out of an RRSP is taxed as income, which means the advantage is lost. This is why it’s good to have highly-taxed assets (like bonds, for example) inside an RSP, while dividend-producers are outside.

Also don’t forget that all RSPs must eventually convert into RRIFs (at age 71). This forces you to start draining off those funds and add them to your annual income. So retirees with swollen retirement plans can see themselves forced into a higher tax bracket, when they could have avoided that if the funds were in non-registered investments.

Finally, like Jason, many people grow an utterly false sense of security from having their savings in a pre-tax vehicle like an RRSP. A $400,000 RRSP can actually end up being $100,000 less when the money finally makes it into your hands. And that’s at today’s tax levels. I shudder to think what the bill might be when a 30-year-old finally starts collecting CPP in 2047.

So, are these things financial dinos? As puffed up and useless as, say, Kevin O’Leary?

Hardly. There are some very sexy things that RRSPs can accomplish, and none of them have to do with Viagra or knee transplants. They can play a pivotal role in everything from income-splitting to making babies to finding your inner self.

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More tomorrow.

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avatarGarth Turner - The Greater Fool posted Thursday, November 8th, 2012.

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