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It has become very clear to me over the past few weeks that the biggest benefit of a tax deferred account such as a RRSP (Canada), pension plan or a 401K (U.S.) is NOT the tax benefits. It is also not the employer match programs that sometimes comes with them nor the flexible investment options within the plans. These are all great benefits, but in my mind they are not the most important. The most important benefit of these tax deferred accounts is that they lock up your money for a long time and make it difficult to withdrawal money from them!
This benefit is not something that many financial professionals typically talk about. I guess it is not the best selling point out there – put your money in this 401K and you will lose access to it for 10 to 20 years. If you think about it in those terms, then yeah it seems kind of scary doesn’t it? But that is exactly what people should be doing. Money that goes into a tax deferred account needs to be thought of as long term, and once it is in there there is no pulling it out until you are ready to retire.
Both 401K’s and RRSP’s have options available for investors if they do want to withdrawal the money. Called a hardship withdrawal in the case of the 401K, investors are able to get access to money in certain circumstances. For RRSP’s, an individual can withdrawal any amount but the hit to taxes escalates as the amount increases.
I view my RRSP and my pension plan with the mindset that once it is in there I cannot pull it out for no reason whatsoever. The costs are too great. Consider this chart I found at the Globe and Mail:
Click to EnlargeAssuming a withdrawal of $5000, which is not too much in the scheme of things, an investor would be giving up $33,640 over 20 years and a whopping $87,250 over 30 years. That is a lot of lost opportunity. So the next time you are talking with someone about the benefits of an RRSP or 401K, don’t forget to mention the fact that it locks your money up!
(Photo Credit: Davide Guglielmo)
Tax defferend account can save a lot. I have been using them sine many years and there potential is huge. I would suggest every one starting to chose them sincerely
Very good point. I consider all my investments, taxable or not, as long term and therefore untouchable.
I know plenty of young people that have taken money out of retirement vehicles to pay off credit card debt. The tax implications of such a move are terrible, but as you point out the long-term consequences are even more harsh.
You make a very good point. If you could limit people’s ability to trade in tax deferred accounts, many would be better off. There are case where people make some very bad decisions and significantly drive their accounts value down by over trading.
Best Wishes,
D4L
I have a similar opinion as Jack. I don’t consider my investments as something I can access (unless of course there is a major emergency). As far as putting money away for 30 years, I have no problem with that. I have seen enough compound interest charts to know that leaving it alone will make me a lot of money – and I can live with that! 🙂
Yep… I surely meant to write, Jake. 😉
I guess the most important part comes back to discipline and enforcing savings plan. For some (myself included) investing inside an RRSP is not beneficial at this point since the chances are high that I will be in an even higher tax bracket in my retirement income than what I’m at now. But if you can’t enforce savings outside than it’s certainly better to be under an RRSP.
I kind of look at this from another, almost opposite perspective. I find that sometimes people are scared off by “locking” away their money such that they contribute less to their RRSP than they can likley afford. I have a tendency to throw as much as possible into retirement accounts (I have both 401k’s and RRSP’s) knowing that if I really need the money, it’s there. I’ve never even come close to touching either account but I know I save a lot more than I likley would if I thought of it as “locking” my money away for good!
MoneyMusing, I’m sure you’re aware that you can carry forward RRSP contributions. Did you know that you can withdraw the money you hold in your RRSP fairly easily, with no tax penalty (i.e. not added to you income for the year and no withholding) if you haven’t taken the tax deduction? It might be worth making the contributions early if the alternative is spending it. 😉
Telly – I agree, it’s hard to lose money in a rrsp unless you have to take a whole bunch out at once.
f you haven’t taken the tax deduction?
I don’t think the part about not paying withholding tax is true – I believe most institutions charge withholding taxes automatically regardless of how long the money has been in the account. You’re correct that you won’t owe the gov’t any tax on that money, in fact you’ll get the withholding tax back.
Mike
Great point, Dividend Guy, but I can see why the investment firms don’t advertise that part. It’d frighten people. Still, it is a definite perk and incentive.
Money Musing, Telly is right. You can contribute to an RRSP, but you don’t have to claim it until you’re good and ready. The tax returns and software are even programmed for this: “Enter the your contributions for 2006. Enter the amount you wish to claim in 2006.” It then carries forward the difference, and your Notice of Assessment will show both figures. I contributed about $25 a month back when I wasn’t paying any taxes, and didn’t claim any of it until I was solidly in a tax bracket. Then I received a nice chunk of it back all at once, and in the meantime I wasn’t incurring taxes on the compound growth my investments were undergoing.
Mike is also right I believe, your investment house is likely to automatically withold the taxes when you withdraw unclaimed RRSP funds, but you’ll get it back come tax time. I don’t know this for certain, however, as I’ve never taken money out of the RRSP.
Mike & Fecundity,
I guess I assumed that there would be no withholding on the amount withdrawn but I could very well be wrong (it wouldn’t be the 1st time ;)). I do have a friend that has done this but it may have been warranted in his situation (due to a foreign tax credit situation). I’ll ask him about it.
I would guess though, that capital gains and dividend taxes must be paid…
Telly – if you withdraw from an rrsp you just pay the withholding tax and that withdrawal gets added to your income. You don’t have to worry about paying any cap gains or divs since they were earned inside the rrsp.
Mike
Mike – I was referring to money in which a deduction wasn’t taken. For example, if you put $100 into an RRSP but never took the deduction and earned $10 for a total of $110, I would imagine you would have to pay capital gains or interest on the $10 if you withdrew $110.
Telly – I know what you mean. It doesn’t matter if you didn’t take the deduction, with holding tax applies to all redemptions from an rrsp account. If you contribute money into an rrsp and then three months later you take it out, I believe the best thing you can do is just do the withdrawal, pay the withholding tax, claim the contribution at some point in the future and move on.
If the time interval between the purchase and redemption is small enough you might be able to get the trade cancelled which is a different situation.
Mike