At first sight, the idea that a teenager contributes to his RRSP may seem far-fetched. At this age, young people have other ideas in mind: smart phone purchase and payment of monthly fees, purchase of their first car, or the funding of their post-secondary education. Yet contributing to your RRSP as early as possible has only benefits.
As a first benefit, there is the learning of savings. To paraphrase David Shilton in his famous book « A Rich Barber », one must learn to pay for oneself. In his book, Mr. Shilton recommends putting 10% of his income aside. For our part, we recommend that a young person puts at the beginning of his/her career 18% of his/her income, which is the maximum limit allowed for RRSPs. He/she will contribute the same amount to his/her RRSP the following year when the eligible contribution amount is given. In this way, the young person learns quickly to live with the concept of savings and it is likely that this will become an automatism in the future.
This habit of saving leads us to the second advantage, which is financial education. It has become a hot topic in recent years with the creation of the Financial Literacy Task Force. In fact, statistics on the financial literacy of Canadians are simply frightening. CIRANO published a very thorough study in October 2011 on the financial literacy of Canadians managing their own portfolios averaging $ 200,000. The study showed that these people who should have a very good financial knowledge actually got a poor score: only 5% scored above 66%. Starting to save at a very young age can encourage young people to learn about investments and the stock market, to learn the concept of risk / return, to learn how to establish a realistic budget, and therefore understand the pitfalls of easy credit and over indebtedness.
The third advantage is the magic of compound returns, which some authors call the exponential power of returns. But, you may ask yourself, what is the exponential force? Let’s take an example to illustrate this without going into the details of the calculations. Imagine two students starting to work, Pierre and Julie. Both are 15 years old and plan to study for the next 10 years. During their studies, they will have an employment income of $ 10,000 a year. Julie wants to contribute to her RRSP $ 1,000 a year at the beginning of the year during her studies, which she plans to complete at age 25. Pierre decides to take immediate advantage of life and thinks he will start contributing to his RRSP at the end of his studies, at age 26. Considering a return of 5%, Julie will have in her RRSP the sum of $ 12,578 at the end of her studies. Afterwards, Julie will not contribute to her RRSP until she retires, having obtained a job that benefits from a pension plan. When she retires at age 67, 41 years later, still assuming a return of 5%, the RRSP will be worth $ 92,976. If Pierre wishes to end up with the same amount as Julie in his RRSP at age 67, he will have to invest $727 each year starting at the age of 26, for a total of $ 29,807 (against $ 10,000 for Julie who decided to invest early in life). It is easy to realize the huge benefit of contributing to your RRSP as soon as possible.
Now let’s look at some pitfalls to avoid in managing our RRSPs. The first one is a trap that has a direct link to the previous “RRSPs for teenagers” theme, which is claiming the deduction at the wrong time. It is not mandatory to claim a deduction for the year 2017 if you have made a contribution for the year 2017. It is quite possible to postpone in the future the deduction if this benefits you. Let’s go back to the example of Julie, who contributed $ 1,000 each year for 10 years while she was in school. Claiming an RRSP deduction makes no sense as there is no tax benefit from the deduction. It is better to wait until Julie gets a better paying job and thus can enjoy greater tax savings.
The second pitfall to avoid is choosing the wrong RRSP investments. Indeed, if you have a non-registered (regular) account, it is better to place in the RRSP, as a priority, the securities that generate interest (GICs, bonds, fixed income funds) and leave the shares in your regular account. Thus, you minimize taxes because capital gains are taxable at 50%, dividends are eligible for a tax credit, and interest income is taxable at 100%. Of course, if there is still room in your RRSPs for stocks or growth funds, do not hesitate.
The third trap is to avoid using your RRSP to pay consumer debts. Keep in mind that when you make a withdrawal from your RRSP account, the withholding tax applies: for withdrawals of $ 5,000 or less, the combined total (federal and provincial) tax is 21%, 26% for withdrawals of $ 5,001 to 15,000 and 31% for withdrawals of $ 15,001 and over. There also is likely to be a balance of tax payable at the end of the year depending on your marginal rate. We note that the amount paid in taxes probably exceeds the interest rates on short-term debts. It is better in this case to turn to a debt consolidation. In addition, unlike TFSAs, withdrawals from RRSPs do not entitle you to a new contribution for your RRSP in the future.
RRSPs are an effective accumulation strategy that must be adapted to each investor’s situation. Do not hesitate to contact us to discuss and optimize their use.
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