How to optimize your RRSP? Short term vs long term investment strategies
By taking a long term investment strategy approach, you can optimize your investments better and ultimately have more money when you want it for your golden years.
Why are we talking about long-term investments? Well, you know it’s RRSP contribution season. Maybe you’ve already thought about how much you should contribute to your RRSP in 2017. If you’re like most folks, you’re focused on short-term optimization, which is easy but involves a fair bit of guesswork.
Let’s compare these two ways of investing in RRSPs.
Short term optimization. Quick and easy, but not ideal
Short term optimization focuses on saving the most tax possible without considering anything else. In otherwise make the maximum contribution to your RRSP that you can each year. Without proper planning, this can result in the tax you save being less than the tax you pay in retirement.
Consider a 30 year old person who earns $100,000 a year who currently has minimal living expenses and lives frugally. She can afford to save the maximum amount of $18,000 per year or $1,500 a month.
However, continuous saving at this rate means that this person will have to (remember, mandatory withdrawals) withdraw at least $141,000 per year starting at age 71. (Assuming 6.0% rate of return, her RRIF will have a value of $1,910,400 at 71 and she will have to withdraw 5.38% of the value in that year.)
Assuming current tax rates, receiving full CPP pension, the outcome is a tax bill of ~$29,500 and fully clawed back Old Age Security Pension (~$6,500/year value).
The good news is that diligent saving and it has payed off and she is quite financially independent. The bad news in that she is paying a lot in income tax in retirement (as having OAS clawed back). The better approach would be to keep her taxable income under $85,000 to minimize taxes and claw back and supplement her income needs with other accounts.
Her income distribution will look like this.
Trying to guess how much money you will earn in the future is pretty difficult for most of us. Tweaking contributions as you speculate on future tax brackets is an arcane endeavor. Avoiding savings because you think it is not optimal, isn’t always optimal. These are not ideal ways of handling short-term investing.
There is a very simple process you can follow that will let you know exactly how much money you should save in your RRSP while optimizing all three stages of your financial planning life cycle.
Simply save enough money in an RRSP to cover your current living expenses in retirement until age 100 and divert the rest to your TFSA or other savings accounts. This is called “long-term retirement planning”
Long term retirement planning, made easy
Start with your income.
Let’s keep the example from above: $100,000
After subtracting taxes, savings and deductions, your net income need is $64,500 per year.
Gross it back up including taxes: $83,000/year
Subtract CPP benefit in retirement: $12,780 (in 2015)
Saving using your RRSP and TFSA, your income distribution will look like this:
The overall value of the portfolio is less than $100,000 lower than shown above where all savings are in RRSP, but the after tax value is much higher as 1/3 of the tax optimized portfolio is in TFSA. Withdrawals from TFSA are tax free, so you can splurge on travel, golf memberships, outdoor adventures without compromising your lifestyle income and without changing your tax brackets.
A WealthBar financial advisor can help walk you through how much to contribute to your RRSP or TFSA. We can help you manage a long-term strategy for generating wealth. Interested? Check out our pricing and open up an account with WealthBar today.