Thursday, April 19, 2007

How Much Do You Need to Retire - Part IV

So far this week we have looked at your yearly spending in retirement (Part I), government programs (Part II) and company pension plans (Part III). Today we are going to look at RRSP's and taxable investment accounts.

1) RRSP

Both of these types of account are very similar in the fact they can be just about any investment product. The only real difference is how they are taxed. In a RRSP you get a tax refund on the income tax you originally paid for that money and then that money can grow tax free until you withdraw it (presumably in your retirement).

Despite the almost universal advice that investing in a RRSP is a good thing by most mutual fund companies and banks it actually doesn't help some people. An RRSP is used to delay the tax not avoid it. So if your in the lowest income bracket already and you expect to be the same in retirement it really doesn't give you much of a break. Yet as you climb tax brackets an RRSP becomes increasingly useful since you hope to avoid the high tax rate now and take it out at a lower tax rate in retirement.

Case in point my wife doesn't have her own RRSP. Instead we buy her a Spousal RRSP which gives me a tax credit and puts the money in her name. The idea of the this is to split the RRSP's I would normally buy between two people so when we pull them out in early retirement we can reduce our total tax paid on the money. So for example instead of withdrawing $20,000 a year in my name, we can split the money up and only pay tax on $10,000 each.

For those of you who were paying attention during the last budget you might ask, but can't we split pensions now? Yes you can split pensions, but the government never said you could split an RRSP. In fact the only way an RRSP fall under those rules if if you covert it to a RIF and your older than 65. So keep buying those Spousal RRSP for early retirement.

In my case we have around $12,500 in my RRSP and $5200 in my wife's Spousal RRSP. Using that same calculator from yesterday's post, I input the following:

My RRSP is at $12,500
Adding $135/month ($100/month + 35% tax refund)
At 5.5% interest (to keep it in today's dollars)
For 16 years, I end up with $71,490

Spousal RRSP is at $5,200
Adding $135/month ($100/month + 35% tax refund)
At 5.5% interest (to keep it in today's dollars)
For 16 years, I end up with $53,926

So in total I will have $125,416. Now assuming I'm only going to use these from 45 to 65, I can use 5%/per year of my total or $6270/year. By the way 5% is a bit of a conservative estimate since the money will be gaining interest as I pull it down (20 years x 5%/year = 100%).

2) Taxable Investment Accounts

As I mentioned before a taxable account is similar to an RRSP with the choices you have to pick from. The major difference is how you are tax on your gains. You need to understand the differences between interest, dividends and capital gains. For details I suggest reading this. The overall summary is capital gains and dividends are better than interest in a taxable account.

Currently my cash flow will allow me to save an additional $700/month beyond my current RRSP savings. My wife currently has $5000 in her taxable account.

Starting at $5,000
Adding $700/month
At 6.5% interest (the higher interest rate here reflects how this account is more aggressive)
For 16 years, I end up with $226,773.

Summary

Alright I agree $226, 773 looks like a lot of money, but there are still some significant costs this has to cover, but I can pull down almost $6270/year from my RRSP's. So in tomorrow's post I'll break down how these numbers relate to each other and how to simulate a draw down on a large pool of money.

3 comments:

Investoid said...

Good post. I wonder what the tradeoff is between the income tax split in the future versus you giving up economies of scale now. For instance, splitting your RRSP money into two accounts makes it more difficult to reach the minimums for some mutual funds, and increases the transaction costs on a percentage basis for stocks and ETFs. In both cases, your rate of return is inferior than it could have been, but obviously you are benefitting tax wise later on.

Unfortunately I don't have time to do the analysis, but I suspect if your RRSP is going to grow to a large size and you will be taking out more when you retire, then the tax benefits outweigh the above costs.

Mike said...

Investoid, one thing to consider is that if you treat family accounts as one portfolio then you can save on transactions by not duplicating each asset class purchase in every account. For example if you want 5% REITs in your portfolio, it might make sense to only buy that ETF or fund in one account instead of splitting it up.

More accounts will probably mean more transaction costs but it doesn't have to be a factor of the number of accounts.

Canadian Dream said...

Investoid,

Good point. There would be an advantage to having all the funds in one account for fees. But I suspect your right that the tax advantage would out way any additional costs.

Mike,

I actually do have that problem right now with the RRSP's. I'm a bit heavy in Canadian Equities from my wife's account. The problem is I'm running an experiment right now. I switched to all index funds and the wife is still in some more traditional actively managed funds. I'm waiting a year to see how they compare.

CD