It's impossible to calculate what the long term cost would be. If you are maxing out your RRSP's then any future realized tax advantages cannot be invested further into the RRSP, right? (Cause you are already maxed out.) Otherwise any slack you left would be so much less for your future retirement.
Your investment in RRSP grows tax deferred. Investment outside the RRSP you'll have to pay tax on annually.
It took me a while to understand your question because the phrasing made it sound like you were asking about re-investing dividends and distributions. But if I understand correctly, you're really asking about investing the tax refund/credit.
I don't know the details of Canadian tax system, but if it's the same as U.S., then you're not getting a tax refund, you actually never had to pay it in the first place. (The ideal thing to do is to adjust your tax witholding so that you pay less taxes by the same amount, instead of waiting to get the refund the next year.)
Since you say your tax bracket is 30%, that means that you will earn roughly (very roughly) 30% less outside the RRSP. So if you could earn
10% annually in the RRSP, it would only be about 7% outside RRSP. With compounding, that can become a huge difference over decades (2x over 20 years).
That is right. Anyt ax advantages I would get cannot be used to put into the RRSP unless I did not max out. Fornately, or unfortunatley, I have 6 years worth of unused contribution space that I am allowed to carry forward into the current tax year so in my case I would be allowed to reinvest my tax refund.
But do I put all my energy and found money into retirement funding i.e. RRSP's? Should I be maxing out and putting everything into that tax deferred investment when I'm 30? Am I supposed to top that fund up first before anything else?
Keep in mind I have NO DEBTS or credit card balances or car loans etc. I owe nobody a single cent, expect the landlord and the tax people.
In the US, the tax rates are graduated, so that an individual pays 15% for taxable income over $7550, but 25% for income over $30,650, and ultimately, 35% for income over $336,550.
We run the risk of over saving in tax deferred accounts and then paying too much tax at withdrawal. And some other oddities when social security income is added. So the answer in the US is to deposit enough in our employer account (here, a 401k account) to capture the matching funds given by the employer. Then, other savings, post tax.
Not knowing the specifics of the Canada tax code, I'll leave the further comment to someone more familiar with it. JOE
The people in misc.can.invest and can.general know little of financial planning and know far more about buying penny stocks. I am slowly but surely learning Canada's tax codes from google every day!!!!!
In Canada we have 3 or 4 federal tax brackets. Also the provinces have their own tax brackets. The first tax bracket is for income from $1 to $36
500 per year and this rate is $15.25% for 2006 The second bracket is 22% and applies to income between 36 500 and 78 500. So if you made $75 000 you are taxed 15.25% of the first 36 500 and then 22% for the remainder. In my province of Ontario the income tax is 6% for the first 34 000 and 9% for the amount between 34000 and 68000 and 11% on the amount after $68 000.
So In Canada at least people try try try to get themselves into that lower tax bracket by reducing taxable income. Invest in tax deferred retirement schemes is the easiest way to do this and if you get into that lowest bracket you are looking at some nice refunds.
However alot of people borrow short term money to put into those investment shelters and then they take their refund and pay back the loan or a portion of the loan.
However Joe you raised a good point. I picked moderately aggressive growth funds. If these funds have a couple stellar years I could run the risk of getting into a HIGHER tax bracket come time to withdrawal from my retirement tax deferred investments. So maxing out tax deferred contributions could be a negative in the future, esp. if I am scheming to save taxes now in my youth. Since my employer offers no pension or matching contributions I felt I'd have to work twice as hard to give to my plan. But what if my investments did really well in that shelter? I could be saving my way to higher taxes. I would be robbing myself from the past.
So only max out IF your employer matches (that's free money).
I'm glad you raised that point. Since I have a 30 year plan there is real risk of oversaving. I have to read the tax code rules (like they will be the same 30 years from now LOL) and find out what the MAXIMUM withdrawal I can make from these tax deferred investments once I am retired and convert the plan into income. IF there is no max then it could be tax trouble down the road. If there are Maximums on withdrawls maybe I won't pay alot of tax on any potential oversavings.
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And so the advice I've come to offer here, to reasonable acceptance, is that one should diversify across their taxable/ non taxable accounts as well [as diversifying amongst asset classes]. So at retirement you stand a chance of controlling to some degree where the income will come from and be able to moderate your tax burden a bit. In the states, we also have the issue that our 401k withdrawal is 'ordinary income' and taxed at one's higher, marginal rate. Post tax money giving off dividends and/or long term gains are taxed at a favorable 15% maximum rate. So, money put in pre-tax, not matched, can cost the investor more in the long term. It looks like the Canadian structure is similar, in that sense. JOE
Is this really true? I thought the general consensus was to get the employer match, then do the Roth (where you invest post tax but the gains are tax free) and then again go back to the traditional plan and max out. I haven't seen anything that says to get the employer match and then look to post-tax saving. If the employer didn't match anything, the above logic would imply that all savings should be post-tax.
Also, I think the advice would vary on income level. For someone with very high income, it probably doesn't hurt to save as much as they can in tax-deferred accounts.
Yes, the advice would vary based on income. Also - I was replying to a Canadian poster, I don't know if a Roth type vehicle was available to him. Matched 401, then Roth or post tax IRA deposit with an eye toward Roth conversion. Side by side, a non-matched 401 vs post tax accounts are not quite a no brainer, but I've written spreadsheets that show that even with the tax deduction up front, the loss at the same rate upon withdrawal is a hit. The post tax savings enjoy a lower tax rate for Dividends or long term gains. So I do believe the 401k needs to be scrutinized a bit when deciding how heavy to invest. For example, a 50 year old who now needs to save as much as he can for retirement with little saved. He may easily go from a high bracket to the 15% bracket at retirement. 401 to the max. A young person with good prospects starting out in the 15% bracket probably shouldn't save in the 401 beyond the match. For her, the Roth is the best way to go.
Let's take a step back -- try not to let the fear of taxes blind us to the actual numbers.
Here's a question. Would you prefer to pay $10,000 per year in taxes or $1,000,000 per year in taxes? For myself, a no brainer. I'd pay the $1M because that means my income is $2M versus paying $10K of taxes on $30K of income.
Getting back to your situation, the money you put in now grows tax-deferred. So let's run some simple numbers to see what happens. Say you put in $10K a year post tax versus $13.3K pre tax @ 10% growth,
100% distributions, 25% tax rate now and future. Here are the cash-out schedule for years 1-10.
Year 1: 10,000 post tax versus 10,000 tax deferred cashout
After 10 years, you're talking 12%+ for tax defered over a fully taxable account. Keep running the numbers and you see 32% after 20 years. After 30 years, it's 59%. So that extra 59% might be taxed at a higher bracket. Go back to my hypothetical question about how much taxes you'd rather pay. That still leaves you with a higher post-tax amount assuming you took everything out at once. (You do have the option of taking out X amount every year to stay within some arbitrary tax bracket.)
Now it is more complicated than this. Using low turnover index funds will reduce the yearly tax drag for taxable accounts. Capital gains/qualified dividends may or may not be taxed better depending on the political climate. Global/national economic picture might be different forcing higher taxes all around. But I'd certainly plan for overinvesting versus underinvesting.
Your math is compelling, but makes some assumptions that may be right or wrong. Are you assuming the 401(k) has the same expenses that the post account funds do? In my reply to the OP, I should have pointed out that
401(k) fund expenses, good or bad, should be taken into account. Try adjusting your calculations using .20-.40% annual incremental expenses and the advantage fades quickly. Also, it's been discussed here that there are phantom rates as high as
50% which hit when additional income causes Social Security to be taxed. That situation calls for post tax money. Lastly, consider this - in the final year one works, in the 15% bracket, he saves in the 401(k), but in the very next year, the first year of retirement, starts drawing enough that he's in the 25% bracket. Of course this can work in reverse, the one year deferral saving him the
10% difference. In the end, I didn't claim the pre-tax savings is always bad or good, just that there's a need to be aware of the possible trap at the other end. Given that tax laws can and do change, not putting all your eggs in the pre-tax basket seems sound advice. JOE
At least in the US, there are other things to keep in mind. Most tax-deferred retirement plans are protected in case the person gets sued and/or goes bankrupt. You also can't make much in terms of catch-up contributions, so I think it makes sense to take as much advantage of them while you can. I've always thought of maxing out on the 401(k) as a no-brainer and I've yet to see something that can convince me otherwise.
Obviously, things get complicated when you take in all the factors. I already issued that caveat. My post was mostly addressing this quote from the OP:
"But what if my investments did really well in that shelter? I could be saving my way to higher taxes."
The statement just screams to me irrational fear of taxes. Throwing away higher possible net-after-tax returns because the total $/% of taxes is higher? Crazy.
Well I was the OP and the whole question thread started about what to do with my tax refund that was given to me specifically because I invested in a tax deffered plan. I also as the OP said this was my first year of investing so I have some pretty silly question I'm sure. But shouldn't careful consideration of taxes be a factor to those of us who are blue collar worker types?
Definitely tax consideration is a big factor, that's why RSPP is better. You shouldn't be afraid of earning more money on account of paying more taxes. Keep in mind that tax brackets are marginal, you will never be worse off hitting a higher tax bracket. The bottom line is that the exact same investment in the RRSP will result in more money in your pocket than outside RRSP.
One question for the OP - Do you know what the expenses are for the funds within your RSPP? It would be expressed as a percent, say 1.2%, or hopefully in basis points as in 25 bpts (which is .25%). This would help the precision of the replies. Assuming the fees are low, as low as you could find outside the account, I lean back toward this answer. If the fees are higher, that pushes me back to my original position.
Disclaimer - the first I remarked on this I was using a spreadsheet written for VA comparison to taxable accounts. The minimum fee of .25% still added up over time to negate the benefit of tax deferral. The detailed numbers wyu posted set my error straight. JOE
Traditional IRA, funded with pre-tax dollars, then the entire amount is taxed upon withdrawal. If that's the case, that's a huge tax savings over non-sheltered accounts, much more than potential expense ratio differences. If you're earning an 7% annual return with a non-sheltered account, you could be earning 10% return with an RRSP. That's far more than expense ratio differences.
The fees are high. In the Tax Deferred holdings I have 3 mutual funds, all by Hartford. Hartford Funds in Canada are managed by another Mutual fund company. I have an aggressive US mid cap growth fund, A Canadian large cap fund that invests in dividend stock only and an income fund that is about
40% bonds (Canadian Government and Corporate bonds, 55% Canadian mixed mid and large cap stocks (not all are dividend paying and some stocks are actually trust companies) and 5% Term deposits.) I contribute once per month equally to all funds. Each MER is around 1.6% although the aggressive growth I think is lower maybe 1.2%. Past performance suggests I should get about 6% to 8% average over the next 3 years. The aggressive fund has lost money in the past esp. 1999 and 2000 and 2001 with steep declines but has also gotten a couple high returns in the 14% the last few years I think.
Once I get over my fear of investing and become more aware and savvy I will prolly take my aggressive growth moves on ishares or etfs and take advantage of low MER's. However in Canada discount brokers do not charge commissions or trade fee for buying or selling mutual funds I think. But It'll be a few years before I manage my own investments. Right now I'll pay a planner his
5% in intial deposits and the fund companies their 2% in loads or whatever it is.
I've only been in the funds for a couple of months. I'm brand new. I asked the financial planner to try and get me 7 or 8% but that I would settle for 6% and I'll be very happy. Interest rates in Canada on short term deposits and interest investments are about 4% for 1 year or 90 day and
5% for 5 year give or take a few basis pts. In Canada interest is taxed at your FULL rate rate. Dividend gains are taxed at Half your tax rate. In a tax differed holding of course no taxes. I do hold mutual funds outside a tax deferred account too and I will be concentrating on these before the RRSP or retirement funds (I'm 30 after all).
One other fact in Canada is we are allowed to use our Retirement savings plan to fund the cost of our FIRST house, up to a maximum of $20 000 per spouse with no tax penalty. I would like to purchase a house so I can contribute to a retirement plan as a method for purchasing my first home although personally my desire is NOT to use retirement plan money for my home. There is no tax penalty and you have 15 years to repay your retirement fund back however if you take the money out of your plan into your home then it isn't growing for your retirement tax free.
The numbers are very workable and I printed your response to study further. Thanks to you for the effort in answering I really appreciate. Thanks to everyone as well!!!
These fees are too high. So high I believe they wipe out the benefit of the tax deferral. The types of funds you want should easily be found for under .5%. An extra 1% per year will certainly drag your returns down. There's no correlation between paying the higher fees and getting a better return. I'm sure you'll see further comments as people read your reply on the fees. JOE
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