It's that time of year again when Canadians rush out to make their RRSP contributions. When I think of RRSPs, I often think of a bucket or a box of money. When you put money into that box, you get some tax savings but when you take money out of the box, you have to pay the tax back. For Serge, a Canadian Baby Boomer, RRSPs are “simply another way for the government to stick their hands and their noses into my personal finances.”
Serge is not a fan of RRSPs. In his words, he prefers to “think outside the box”. While there is a place for RRSPs for many Canadians and their retirement plans, there are more and more Canadians who think like Serge. Suffice it to say that there are advantages and disadvantages to everything including the RRSP. However, there is a camp that believes in investing outside the RRSP. Let's take a look at some situations where you should think outside the box and invest outside the RRSP.
The RRSP is a Registered Retirement Savings Plan. By nature of the name, it is an account designed for longer-term savings and monies that are ideal for retirement when you no longer have income from work. If you are saving to spend, you are better off investing outside the RRSP. Some examples might include saving for a wedding, a holiday, a car or in my case a big screen plasma TV. Far too often, I see people putting money into a RRSP only to see them take it out to spend a year or two later. The problem with saving to spend in a RRSP, is the tax consequence at the time of withdrawal is too great. If you pull out of RRSPs, you may have to pay 25% to 40% in tax, which means you only can spend 60% to 75% of every dollar you take out of an RRSP. If you are saving to spend, you are much better off doing it outside the RRSP.
Along the same lines, if you are trying to build an emergency fund, the RRSP is not ideal. Building an emergency fund is much better if it is done outside the RRSP for the same tax reasons as withdrawing from spending accounts. Hands down, when you need money for an emergency, you will want to access non-RRSP funds because the tax hit out of an RRSP can be very painful.
Funds for liquidity
Liquidity can mean many different things to different people. In most definitions, liquidity refers to the ease that an asset can be converted into cash quickly. Although an RRSP can be liquid in terms of being converted to cash, it has potentially severe tax consequences when converted to cash. For ultimate liquidity, investing outside the RRSP is a far superior strategy.
Low tax bracket
Many accountants will agree that if you are in a low tax bracket, you lose a lot of the benefits of a RRSP tax deduction. In these cases, you may be better off investing outside the RRSP for both the short term and the long term.
Defined pension plan
If you work for an employer that offers a defined pension plan, your pension could be the cornerstone of your retirement plans. In a case where you stay with the same employer for a long period of time, you may be better off saving outside the RRSP to enhance your financial future. Having a non-RRSP investment in conjunction with a pension plan is a very powerful combination that will give you a lot more flexibility into the future.
Borrowing to invest
When you borrow money and invest into RRSPs, the interest on the loan is not tax deductible. However, if you invest into a non-RRSP portfolio, you can potentially write off the interest on the loan.
As a result, leveraging really requires investing into non-RRSPs to maximize the true tax benefits. In fact, advocates of leveraging can show mathematically, that borrowing to invest outside the RRSP is better than investing directly into an RRSP. My only word of caution is that in reality, leveraging has risk and before you go out to borrow to invest, make sure you understand the risks.
Tax planning makes all the difference
It's not about how much money you make that counts but how much money you keep after the government gets their hands on your investment.
While it's true non-registered investments don't enjoy the same tax-sheltering of your RRSP, you can select investments that complement those in your registered plan and minimize your yearly tax bite while maximizing long-term after tax returns.
Often I get asked whether it is better to invest inside RRSPs or outside RRSPs. What I can tell you is that for me, I do both. I can also tell you that investing outside RRSPs requires a little more hands on attention to ensure that tax-smart strategies are being employed. So the next time someone tells you that RRSPs are the only way to invest for the future, remember there are many situations where investing outside the RRSP makes sense.