Every year come tax time, we all hear the term RRSP being thrown around. With a bevy of financial acronyms being tossed around, many can overlook the RRSP without realizing that it could be the single most important tool for financing your retirement. In this article we will be looking at the RRSP and the ways that it can be used to grow your money.
Benefits of RRSPS
Before getting into the details of an RRSP, we must address the elephant in the room. What is an RRSP, and can it really lower your taxes? A registered retirement savings plan, or an RRSP for short, is a tax-advantage account created by the government for the purpose of encouraging people to save for their retirement. The beauty of an RRSP is that contributions are not taxed at the point of deposit, rather, they are taxed once they are withdrawn (presumably during retirement) when the owner of the funds is likely in a lower tax-bracket. As of 2021, the owner of an RRSP can make a yearly deposit of up to $27,380 or 18% of their past years income – whichever is lower. The amount deposited into the account is deducted from the users taxable income. For example, if you reported $50,000 in taxable income, your federal income tax rate would be 20.5%, however, if you were to deposit $5,000 into an RRSP, your taxable income would now be $45,000 meaning that you would fall into a lower tax bracket that carries an income tax rate of 15%. Many use the RRSP for its tax benefits, however once the money is deposited, no further action is taken. Since many RRSP savings accounts in major Canadian banks carry a very low interest rate, when inflation is taken into account many are likely losing money. Fact of the matter is that opening and funding an RRSP are only the first steps, choosing a plan to grow your money is what will truly fund your post-retirement dreams.
Who can Invest in RRSPS and What can you hold in your RRSP
Any Canadian citizen under the age of 71 who pays income Canadian income tax can open an RRSP (those under 18 require written consent from their guardian) but many get lost in the plethora of investment possibilities. Here we will look at some of the most popular courses of action that come with owning an RRSP and discuss their pros and cons. First we must look at the rules that come with investing the funds in an RRSP. Prohibited uses of said funds include Businesses in which you have an interest of 10% or more, precious metals other than gold and silver, shares in private holding and private foreign companies, debt you own, and personal property. Though this may seem like a long list, the permitted possibilities are still quite attractive. When choosing a course of action, one must decide how much risk they are willing to accept. The general rule of thumb is that higher risk leads to higher reward, however, the higher the risk, the more likely you are to lose money. With that in mind, younger investors are typically more inclined to invest in riskier options while those closer to retirement are more interested in safe, long-term investments. In the following paragraphs, we will discuss both the high and low risk investments so that you can see which is best for you.
Low Risk RRSP Investments
When it comes to low risk, the first, and easiest option is to leave your funds in a savings account, however as previously mentioned, this is not an advisable option as the small amount of interest earned will almost certainly be outweighed by inflation. Despite many Canadians opting for this option, the likely reason for doing so is lack of information regarding better options. For those looking for low-risk investments, bonds are a much more profitable option. A bond is a financial instrument used as a method of lending money to borrowers. The borrower will typically offer a contract that contains information regarding the length of the term, the principal amount, and interest rate that will be paid. At the end of the term, the borrower will pay back the full amount and the lender will profit from the interest earned. Bonds come in many forms and each comes with a different level of risk and reward. Two of the more popular forms of bonds are government and organizational. Government bonds are exactly what they sound like – a loan to the government in which they will repay, along with interest, at a later date. A government bond is typically very low risk as the government has a very small chance of defaulting on the payment. As of May 2021, a 10 year government bond has a yield of 1.522%. Historically, these bond yield rates have been much higher, reaching 12.5% in January of 1985, however, yield rates have steadily declined over the last 30 years. An organizational bond is very similar, however the institution that is borrowing is a company rather than a government. Since organizations have a much higher chance to default on a payment, they offer bonds with a much higher yield. In general, the higher the yield, the riskier the bond. This is why despite low yields, government bonds are still a popular choice.
When it comes to higher risk investments, stocks are the holy grail. Investors all over the world buy and sell stocks and RRSP owners who aren’t afraid of risk should definitely consider playing the market. Buying a stock is just like buying a small piece of a company. If Apple were to have 100 shares on the market and you bought 5, you would own 5% of the company. Stocks come in all types of shapes and sizes. Stocks in well established companies, also known as blue chip stocks, typically carry the least amount of risk. These companies are also more likely to pay dividends than a smaller, growing company. The major downside with these stocks is that they are typically quite expensive. The other option for the high-risk, high-reward investor would be small start-ups. These are companies that have a low stock price but a high potential for growth. For example, if you purchased Amazon stock in 1997, your investment would have grown by nearly 200,000%, that’s right, 200,000! Keep in mind however that for every Amazon, there are thousands of companies that end up bankrupt. With that being said, stocks can be a great investment for the skilled investor, however no matter how certain things look, every stock comes with a certain level of risk.
Mutual Funds & ETFs
For the investors who are enamoured by the stock market but would like to minimize risk, there are mutual funds and ETFs. These investment vehicles allow the user to invest in a variety of stocks at once. A mutual fund is professionally managed by a finance professional, these funds can contain a wide variety of assets such as stocks and bonds. A common type of mutual fund is an index mutual fund which mimics a stock index. The Dow Jones, TSX, and nearly every stock index has a mutual fund that is aligned to its performance. An exchange traded fund or ETF is a highly-liquid investment that is traded on the stock market. ETFs hold a basket of assets, typically from a similar industry or region which allow an investor to bet on an industry’s success without having to choose a single stock. These financial instruments allow investors to play the market without exposing themselves to the same amount of risk as purchasing an individual stock. When using an ETF or mutual fund, even if one stock crashes, the investor still has a chance to profit if the rest of the portfolio does well. Over the last 10 years, the stock market has grown at a rate of 13.9%, even when taking inflation into account, the real growth rate is still 11.9%. With numbers like these, it’s no wonder that so many people have made a career in the market. However, any financial expert will tell you to diversify your portfolio as any stock could rise or fall.
Gold and Silver
The final option that we will discuss are precious metals. Though investing in many metals with RRSP money is not permitted by the CRA, gold and silver are allowed. Both of these metals have many who love them, and many who despise them. Gold has done significantly better than silver over time and has become a very popular investment. A $100 investment in gold made in the year 2000 would be worth over $600 in 2021, however, many believe gold to be risky and with the rise of cryptocurrency, plenty of investors are staying away from the shiny metal. Gold is typically viewed as a safe haven for investors when the economy is looking bearish, due to this, the price of gold typically rises during periods of economic uncertainty such as during the recession of 2008, and the COVID-19 pandemic. Though it typically falls after economic stability returns, gold could be a solid investment during the next recession.
With all of these options on the table, it is hard to see why so many Canadians either do not have, or inefficiently use the RRSP. A potential gold mine that can offer tax relief on nearly anyone, an RRSP is a fundamental tool for a financially stable retirement. Though some have taken their investments into their own hands, it is much more common to give control to a financial professional. The former is not advisable to those who do not have ample knowledge and experience. With help from an expert and consistent contributions. Your RRSP could grow beyond your wildest dreams and make your post-retirement aspirations a reality!
I am not a financial advisor, this is for educational purposes only. This is NOT financial advice.
I am in currently enrolled at the Lang School of Business and Economics at the University of Guelph. I hope to have my Bachelor of Commerce, Management Economics & Finance Degree in 2024