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The Biggest Risks to Your Financial Success Are Behavioural
Author Talbot Stevens
You can significantly increase the value of your RRSPs by understanding and taking advantage of a more effective savings approach.
How you act as an investor and a consumer are the biggest risks to your financial success.
Investing behavioral risks are:
- Procrastinating
- Suspending or reducing savings
- Spending RRSP refunds
Procrastination
Most investors can minimize behavioral risks by combining forced and automatic savings approaches. Two automatic savings approaches are pre-authorized savings and making investment loan payments. As with mortgage payments, the forced savings of making payments on an investment loan locks in a higher level of commitment and discipline. Most investors would benefit from using a forced savings approach to the level that causes no financial or emotional strain, by borrowing to catch up on RRSP contributions.
All remaining cash flow should be invested using an automatic savings approach, by having monthly pre-authorized deposits taken from your chequing account or directly off of your pay cheque. “Paying yourself first” by automatically contributing every month reduces the risk of spending money sitting visible in a chequing account.
A forced savings approach is the most effective solution to the behavioral risks that reduce most investment plans.
Suspending or reducing savings.
Use a more effective RRSP refund strategy.
While they have many benefits, there are also behavioral risks of RRSPs, which are often overlooked. The most significant behavioral risk is that most people do not invest all of their intended dollars towards their retirement goal. In addition, most people have the false impression that they have invested more than they really have.
Important
Example: Let’s pretend that Bob has $1,000 to invest, and he is in a 50% tax bracket (to keep the math simple). Recognize that the $1,000 is an after-tax amount – dollars that have already been taxed. If Bob puts the $1,000 in his RRSP, and spends his $500 tax refund, his net after-tax cost is only $500. Thus, Bob’s after-tax commitment towards his retirement is only $500, not the $1,000 after-tax amount that he started with and intended to save for retirement. Unfortunately, Bob’s RRSP statement reports that he has $1,000 in his account, further reinforcing the false belief that he has invested $1,000 towards his future.
RRSPs often convert after-tax dollars into before –tax dollars inside of an RRSP, which when withdrawn are 100% taxable again. In other words, the common approach of investing in RRSPs and spending the refund reduces the actual amount intended to be saved to an amount that is 22-43% less, depending on your tax bracket. This significantly reduces the potential of RRSP’s for those who have not used all of their available contribution room.
Unfortunately, spending RRSP refunds is the first and most common behavior risks to retirement savings. Directing RRSP refunds towards your retirement goal and reinvesting the refunds will increase your RRSP by the rate of your tax bracket.
Simply reinvesting RRSP refunds is an easy way to increase RRSP savings by 22-43%.
“Gross up” Your RRSP
“Grossing up” RRSP contributions is even more effective. This refund strategy is to borrow enough to maximize your annual contributions, with the balance of the loan repaid within a year. (The final refund strategy is to borrow a larger amount that might take 10 years or more to repay, to “catch up” on some or all of your unused contribution room.)
Gross up to invest all intended dollars
To truly invest all of your dollars intended for savings, you need to use the “gross-up” refund strategy. After-tax dollars equate to a larger before-tax amount inside an RRSP, which we can refer to as the “grossed-up” RRSP amount.
In a 40% tax bracket, $1,000 can be “grossed up” to an RRSP contribution of $1666 as shown below.
Grossed-up RRSP contribution $1666
- 40% tax refund $ 666
NET COST $1000
To calculate the grossed-up RRSP amount that equates to the after-tax amount that we have to invest, use the following formula.
Grossed-up RRSP amount = After-tax amount / (1 – Tax rate)
This formula simply works backwards to determine the maximum amount that we can contribute to an RRSP with the after-tax dollars available to invest, taking full advantage of the tax refund.
To invest all dollars intended for retirement and increase your RRSP savings by 28-85%, make grossed-up contributions to your RRSP.
How to Gross up RRSP Contributions
The easiest way to gross up RRSP contributions and invest all of your intended cash flow is to “pay yourself first” and invest the appropriate grossed-up amount every month using pre-authorized withdrawals from your chequing account.
Just before the RRSP contribution deadline, you can immediately increase your RRSP contribution by 28-85% by using a temporary “gross-up” loan.
Example: In a 40% tax bracket with $1,000 to invest, Bob could borrow an extra $666 to “gross up” his RRSP contribution to $1666. This will produce a 40% tax refund of $666, which completely and almost immediately repays the $666 loan. Using this temporary gross-up loan, Bob is able to increase his contribution to his RRSP by 60% relative to the common approach of spending the refund.
To calculate the exact RRSP gross-up amount for any tax rate, use the “Calculate RRSP Gross-up” option on the Analyses menu.
Hidden Tax Benefits and Increase Cash flow From Investing in YOUR RRSP
Many government support programs, like the Canada Child Tax Benefit (CCTB) are reduced or “clawed back” as your taxable income rises. Thus, claw backs are effectively a “ hidden tax” that reduce the total amount that you get to keep. Any strategy that reduces a claw back results in receiving higher government benefits.
Opportunity. RRSP contributions reduce your taxable income, and thus reduce claw backs and increase government benefits. This means that contributing to RRSP’s not only reduce taxes, but can also “pay you” by increasing the government benefits you receive from programs that are “clawed back”. This extra cash flow from the reduced claw backs can be grossed up to add more fuel to your retirement savings.
Your Optimal RRSP Contribution Strategy
Determining your optimal RRSP contribution strategy consists of finding what portion of your investable cash flow is best used for payments on a catch-up loan (using a forced savings approach), and what portion should be reduced grossed up (using a “pay yourself-first automatic savings approach). Additional cash flow resulting from reduced claw backs is also grossed up for extra contributions.
The optimal contribution strategy is a theoretical best that assumes perfect 100% discipline, which is unrealistic for most investors.
Reducing Behavioral Risk
You do not benefit from a plan that is not acted on and followed through to completion. Financial success is not determined by what you know, or plan. It is determined by what you do.
For a catch-up loan that is well within your financial and emotional capacity, the risk that the forced savings portion of the plan doesn’t get completed is near zero. Thus, the automatic savings portion of the cash flow that is not “forced” to be saved then reflects the behavioral risk of the plan. Since most investors typically have spent their RRSP refunds, it might not be realistic to project 100% discipline level where all of the remaining cash flow is grossed up.
You will benefit most by defining an Action Plan that minimizes behavioral risks, accounting for your own realistic discipline level.
If you have less then perfect discipline, it might be best to commit too larger than optimal RRSP catch-up loan to increase the forced savings portion of the plan. If your less comfortable with investment loans you might prefer using a smaller than optimal portion of your cash flow for forced savings.
Please share this valuable financial strategy with those you care about. The benefits can be immediate, significant and compound for decades.
Written By Talbot Stevens - Talbot is an author of two bestseller books, Financial Freedom Without Sacrifice and Dispelling the Myths of Borrowing to Invest. He is a financial educator, author, and industry consultant. Email talbot@TalbotStevens.com.
This article was prepared by Terry Fay who is an Investment Advisor with Dundee Securities Corporation, a DundeeWealth Inc. Company. This is not an official publication of Dundee Securities and the author is not a Dundee Securities analyst*. The views (including any recommendations) expressed in this article are those of the author alone, and they have not been approved by, and are not necessary those of Dundee Securities.
The particulars contained herein were obtained from sources which we believe reliable but are not guaranteed by us and may be incomplete. The opinions expressed have not been approved by and are not those of DundeeWealth Inc., its subsidiaries, or its affiliates, including, but not limited to Dundee Securities Corporation, Dundee Private Investors Inc. / Ltd., Dundee Insurance Agency Ltd., Dundee Bank of Canada and Dundee Mortgage Services. This website is not deemed to be used as a solicitation in a jurisdiction where this Dundee representative is not registered.
Insurance products provided through Dundee Insurance Agency Ltd.
Only securities related products and services referenced are offered through Dundee Securities Corporation.
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