Since most of us don’t have a defined benefit pension plan, an RRSP becomes even more important when planning for retirement.
When managed properly, an RRSP can grow into a substantial amount. How it’s managed can play a large role in how you live in retirement and how comfortable your financial situation will be.
Everyone makes mistakes with their money, and an RRSP is no different. But continually making mistakes with an RRSP every year can cost thousands in the long run.
Not Contributing to Your RRSP
When finances are tight, it’s easy to blow off RRSP contributions and focus on other things more important at the time.
Maybe your vehicle needs some expensive repairs, or maybe there are some renovations you need done on your home.
Whatever the case may be, it is absolutely essential that you contribute every year to an RRSP.
How much, of course, depends on your own finances – which makes budgeting that much more important.
The easiest way to contribute is by adding it to a monthly budget and making it automatic – that way you won’t even have to think about it.
I contribute monthly to my RRSP via automatic withdrawal. If I had to manually transfer the money every month, there’s a good chance it wouldn’t happen.
Spending the Tax Refund
Since RRSP contributions are tax-deductible, most people think that once they’ve made a contribution they are set and don’t need to do anything further – wrong!
RRSPs create the most value when the tax refund is used wisely – paying down debt, adding it right back into your RRSP or contributing towards your Tax Free Savings Account (TFSA) are all good options.
Related: Hidden Advantages of the TFSA
There is no sense in making an RRSP contribution if the refund is going to be wasted on monthly spending.
I won’t lie – when I get a decent sized tax refund I am always tempted to spend it on something fun. I do usually set aside a small amount for spending money, but the large majority of it either goes into my TFSA or back into the RRSP.
Making Unnecessary Withdrawals
Occasionally I am asked whether it would be a good idea to withdraw funds from an RRSP to pay down debt, do home renovations or even take a vacation. In most cases the answer is no.
Related: Common RRSP Myths
Home renovations tend to go over budget most of the time, so when you budget for is likely not going to be enough to cover the total cost.
I think paying down debt is always a good idea, but those funds should come from your monthly budget – not an RRSP withdrawal.
And taking a vacation is likely one of the worst ways to use an RRSP withdrawal.
RRSP withdrawals are taxable in the year they are taken out, so if your marginal tax rate is 35% and you withdraw $10,000 – you’ll pay $3,500 on the withdrawal.
Personally, I don’t plan on withdrawing anything from my RRSP until I retire – and even then it will be used in conjunction with my TFSA to make sure my tax rates stay low.
When you open an RRSP it is important to name a beneficiary to avoid a huge tax bill if you pass away. If no beneficiary is named, the RRSP becomes part of your estate – and may lead to probate fees and taxes.
For most people (including myself) a spouse is usually named a beneficiary to ensure that the funds can be transferred easily to the spouse in case the RRSP holder passes away.
Not Properly Diversifying
There is always the natural tendency to focus on investing in companies that we see and know the most.
But it’s also important to properly diversify into other markets to make sure you don’t miss out on any market gains.
From 200-2009, the TSX was up 37% and the Dow Jones Industrial Average actually dropped 9%.
But from 2009-2014 the TSX climbed 74%, while the Dow Jones Industrial Average climbed 130%.
No one knows where the markets are headed in the future, but a properly diversified portfolio will make sure you take advantage of gains in other markets and reduce risk through diversifying.
Conclusion: the above list is just a few of the common mistakes people make with their RRSP. I’d say how you spend the refund and avoiding any withdrawals are likely the most important ones.
What do you think are some of the biggest RRSP mistakes an investor can make?