Saving Too Much For Retirement Is More Common Than You May Think
It is unlikely that you would ever regret saving too much, but did you know that it is possible to over-allocate to your retirement savings at the expense of your larger financial picture, and to even unknowingly cause tax inefficiencies?
Retirement saving, much like any other aspect of financial planning, is about finding a balance in managing scarce resources to optimize all outcomes and avoid short-changing yourself. This article helps you re-evaluate your retirement savings and see if you are creating a tax trap for yourself in Canada.
Do You Have a Plan?
For a successful retirement, you need to ensure that your retirement nest egg can provide you with enough cash flow during your retirement years to fund your desired lifestyle, while taking inflation into account and leaving room for unexpected expenses.
To accomplish this, often the best approach is to go through a retirement planning process that begins with your goals (i.e. how much you want to be able to spend each year) and work backwards.
By filling the gap between your lifestyle cash flow needs and any sources of income you may have, such as a pension or business income, you will be able to identify what you need to save and invest each year until retirement. Without this process you are aiming for an invisible target, one you may even be overshooting without realizing it.
In the absence of a plan, you are left not knowing how much saving is actually required to reach your retirement goal, let alone understand what your “goal” really is, thereby resorting to a “best guess” approach which could lead to a shortfall or even an over-allocation at the expense of your larger financial picture!
What About Your Other Goals?
Aggressively saving towards one financial objective, throwing everything but the kitchen sink at it, may feel like the right thing to do, but you may be compromising your larger financial picture. While for many, retirement truly is the “Big Audacious Goal,” it is seldom the only goal or ambition in their lives that they very much want to see come to fruition.
For most people, financial surpluses are finite and therefore savings must be allocated thoughtfully and appropriately to optimize what they can accomplish. Allocating too much of your savings toward retirement may mean that other, nearer-term goals are sacrificed, which could diminish feelings of fulfillment in your working years and even erode your willingness to save.
It is also important to consider that individual goals may and could very well be interconnected, so it is important to view your personal objectives holistically, as one may even help bring about the other. Consider this interesting example. Say that you have a nearer-term goal of buying a property. While saving for this nearer-term goal means drawing savings away from your retirement goal, successfully purchasing this property could not only improve your happiness and fulfillment as you work towards your retirement goal, but also potentially provide you with an opportunity to use the accumulated equity to further support your retirement goal as the new asset appreciates.
Are You Creating a Tax Trap?
You may have heard the long-running debates around the merits of using a Registered Retirement Savings Plan (RRSP) relative to its potential pitfalls, but understanding how this retirement savings vehicle fits within your plan is critical—particularly to ensure that you do not inadvertently make yourself worse off by using it.
The basic premise behind the RRSP is that contributions you make during your working years (or any time until the end of the year in which you turn 71, when your RRSP converts to a RRIF) reduce your taxable income, thereby providing you with tax savings via an increased refund, following which your invested funds have the opportunity to grow tax-free until the time that you draw on them, at which point these withdrawals are fully taxable as income.
The benefit here is really derived from your marginal tax brackets. In Canada, people are subjected to graduated rates such that they often find themselves in a higher marginal tax bracket in their working years than in retirement. This means that the tax benefits incurred will offset the eventual taxes paid. There are a few cautionary notes to be mindful of here.
If you anticipate other significant sources of income in retirement, whether from a pension, a business, or others, you may find that your marginal tax bracket in retirement could be just as high as it is during your working years or even higher, reducing the tax benefits of the RRSP or even increasing your tax burden if you are not careful.
In addition to the fully taxable nature of RRSP withdrawals (or RRIF withdrawals following conversion), there is another potential pitfall to be mindful of when accumulating into this savings vehicle: the value of your RRSP/RRIF can roll over to a surviving spouse following your death to defer taxes, but in the absence of a surviving spouse, the entirety of the account is added to your taxable income in one shot, potentially creating a significant tax liability that could see much of the account go towards paying the tax and not truly form part of your legacy.
The Bottom Line
Saving too much for retirement is more common than you may think. In Canada, saving too much into an RRSP could mean that you will be faced with the difficult decision of whether to pay higher levels of tax during retirement or see a big chunk of your legacy go towards settling the resulting tax bill.
This content is provided for general informational purposes only and does not constitute financial, investment, tax, legal or accounting advice nor does it constitute an offer or solicitation to buy or sell any securities referred to. Individual circumstances and current events are critical to sound investment planning; anyone wishing to act on this content should consult with his or her financial partner or advisor.