Retirement Investment Accounts
Updated March 21, 2023
What happens when you retire and the paycheques stop coming in?
A girl needs cash!
In this article, we’re talking about all the different sources of cash income you can create for yourself to support your lifestyle after the paycheques of your full-time working years stop coming in.
Previously, we covered employer pensions and government benefits. Here, we’ll review the different retirement investment accounts you can build for yourself over the years.
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What’s Inside?
Prefer to Listen?Here’s the podcast episode!
Rather Read All About It?How to Use Your Retirement Accounts to Produce an Income
I like to think of how we use our retirement accounts to produce an income for ourselves like this...
Picture yourself walking through a mountain forest. You’re climbing up and up, footstep by footstep, up the mountain.
That’s what building your investments is all about. Bit by bit, you put money away to save, and it grows higher and higher, until you reach the top of the pile of money you’ve saved over the years.
Now, you’ve reached the top of the mountain. You’ve reached your retirement, the pinnacle, the reason you’ve been saving all these years. Now you can start a new chapter. You’re ready to have some fun heading down the mountain.
You see a crystal clear, gentle river. It’s meandering down the mountain. It would be a lot more fun for you to start this new life journey of getting back down the mountain by using this river rather than hiking all the way back down, afraid that you might fall if things get too steep.
But you’ve planned for this moment. You knew this river was here. You came prepared with a little boat. The name of the boat is your financial plan, the retirement income plan you built with your financial advisor. So, you ride your boat on the river back down the mountain smoothly, enjoying the view the whole way.
It’s a nice visual, isn’t it? So, let’s break it down. When you were walking up the mountain, that was the accumulation phase of your investment accounts. Your working years, saving your money paycheque by paycheque until you reach the top of your mountain of money. And at the top, you’re ready to start the next chapter, retirement.
Now, you’re going to start the de-cumulation phase. Taking money out of the pile every year so you can spend it to live. Using that mountain of money to create a new life for yourself. You can try the difficult way, heading back down the mountain step by step. But you might run into slippery rocks, like economic recessions and falling stock markets and unexpected expenses.
Or, you can get in the strong boat you built called your “financial plan" and ride a smoother retirement, down this mountain of money, down this de-cumulation phase. And when you come across the slippery rocks, like falling stock markets and unexpected expenses, your little financial plan boat will keep you going smoothly, because you know exactly how to steer it. You planned for these slippery rocks in advance.
That’s how I like to think of the accumulation stage of your retirement investment accounts and the de-cumulation stage of those accounts.
Waterfall Method for Retirement Investing
But, while we’re still in the forest, I want to give you another visual that can help keep you sane in retirement when it comes to your investment accounts. It’s what I call the waterfall method.
Let’s say you are ready to retire and you’ve built up your savings. Now you invest it. You’re smart and you want this money to grow so it will last you many years. So, you invest it in mutual funds that are made up of stocks in the stock market. Soon after you start investing all your savings, the world enters a crisis, like the 2020 pandemic. The value of your accounts drop like a rocket. You’ve spent all your life saving this money. What is your instinct? Maybe it is to cash everything out and put what’s left under a mattress.
But, you know the markets will go up again, so you don’t do that. But the fact is, you need money to live off of, so you do need to cash in some of the investments. You’re not earning a paycheque anymore, you need money to live off of. And you’re cashing them in right when they are worth much less than they were yesterday. Right after their value has gone down because the stock market is down. If you kept doing this, you’d go through your money more quickly.
There is a way to avoid this emotional roller coaster, and that is to invest your money using the waterfall method. So, heading back to our forest, picture a waterfall.
This waterfall has three different levels to it. The upper falls, the middle falls and the lower falls. Each level represents a period of time in the next 5 years of your life after retirement. The lower falls we’ll call years one and two, the middle falls, we’ll call years three and four and the upper falls is year five and all the years that follow until the end of your retirement and beyond.
Every one of these years, you will need income, right? You need money to cover your expenses. You are in your decumulation phase. And we know how much money you need to withdraw because we figured that out when we talked about mindful spending plans and the 4% rule.
But, let’s use an amount of $25,000 a year for today to keep things simple. We’ll say that every year you need to withdraw an income of $25,000 a year from your retirement investment accounts to cover your expenses. Now, we’ll put that money on the three waterfall steps.
The lower falls we call “years one and two” so we’ll put $25,000 times two on the lower falls. The middle falls we said were “years three and four.” That’s another $25,000 times two. We’ll place that money there in the middle falls. The upper falls is “years five and every other year after that.” We’ll put all the rest of the money you have in the investment accounts there. That money is earmarked for you not to withdraw it until five years from now or later.
Let’s take a step back and look at this waterfall now. How does a waterfall work? Water flows down the waterfall, right? So most of the money is sitting up at the upper falls. You won’t be touching that money for at least five years. But next year, some of that money flows down to the middle falls. It represents the money you need in the next three to four years. Another year passes. Water flows from the middle falls to the lower falls. Now the water is pooling in years one and two. The water in the lower falls is the water you’re going to use to fill up your bucket today and spend it to live your life.
So, out of all that water, the only water you need today, the only money you need today, is from the lower falls. The $25,000 you need to spend this year and the $25,000 you need to spend next year. You don’t need the whole waterfall. You’ll drown trying to tackle the whole waterfall. All you need is $25,000 this year and $25,000 next year. A total of $50,000.
Cash Accounts
That $50,000 we are going to invest in cash. We are going to put it in your chequing account, your savings account, maybe a one year GIC, whatever. But, we’re going to give you the comfort of knowing you have enough money to last you for the next two years. That’s how we’re going to invest the money that is in the lower falls.
Bonds and other Fixed Income
Now, let’s look at the money in the middle falls. This money won’t be going into your water bucket for another three to four years. So, we’re not going to invest it in cash. We want it to earn a little more interest, or a little higher rate of return. That means taking a little more risk investing it. So, this money we’ll invest in things like bonds, or mutual funds that invest in bonds. Bonds are simply money that you are lending to companies or the government and they pay you back interest and pay you back the money you lent them later. We have two years worth of income in the middle falls, that’s $25,000 times two, that’s another $50,000. We’ll invest that in bonds.
Stock Market or Real Estate
Now we have the upper falls. That money won’t flow down to us for another five years. We want this money, this reservoir of water, to grow so it lasts for a really long time. This money, we will invest in the stock market, or in real estate, or other things that are more risky or tie our money up longer and therefore provide a higher return.
You now have your three sections of the waterfall invested and time goes on. Suddenly, an event like the 2008 financial crisis comes along. The value of the money in your upper falls drops by 35%. In essence, it creates a drought. The upper falls are not only not being replenished by rain, they’re drying up fast. Do you sell everything? Do you open the dam and flood the valley? No, you have already taken out the buckets of water you needed from the lower falls. That’s all you need. It will last you two years. And you know that a year from now, the rain will come and it will replenish the upper falls. You don’t need that water for another five years, there’s plenty of time for it to replenish.
What about the money in the middle falls, the money invested in bonds? Well, when the stock market goes down, money usually flows into bonds and increases their value. Stock market investors get scared, so they take their money out of stocks and purchase bonds with it. That causes the value of bonds to rise. So, the money in the middle falls is at more risk than the money in the lower falls, but not as much at risk as the money in the upper falls.
Here’s the main point I want you to take from this. You don’t need to access the whole waterfall at one time. If you have your two little buckets, they will last you two years. You can’t control the stock market just like you can’t control rain and drought and all the other things that are happening to the waterfall. But you trust that they will replenish because you’ve seen over and over again, the rain eventually comes. The stock market eventually goes back up. And the reservoir in the upper falls will be replenished. Don’t make the mistake of emptying the reservoir by opening up the dam and taking all your money out of the markets when markets go down.
How Long is a Market Cycle?
You may wonder, why have two years worth of income needs in the lower falls for you to use to fill your buckets? Why not have more? Or less? The answer is that when stock markets go down in value, what we call a bear market, values continue to drop for six months to a year on average historically and then take six months to a year to return back to where they were before. That’s a total of one to two years.
The perfect example of this was in August 2008. The value of many stocks went down 20%, 30% and kept dropping until March 2009, seven months later. But then, values began to rise quickly. We don’t want to try to draw money from the stock market while values are down, we want to draw from the gains we receive when we invest it, so that all the money in our investment accounts lasts longer.
If we have one to two years of cash set aside, plus another two years invested in bonds in our middle waterfall for a buffer, that’s enough time to weather the storm of the average bear market and still keep the largest amount possible invested in stocks growing for us.
So, by understanding and using the waterfall method, you can remain zen through any ups and downs the stock markets encounter.
What Types of Retirement Accounts Can You Own?
That’s how we will invest our investment retirement accounts. What types of retirement accounts can you own?
RRSPs
The first is the RRSP, or Registered Retirement Savings Plan. You can either own one of these yourself through a financial advisor like me, or a bank, or through your employer if they offer one.
Why do people like this particular plan? For several reasons:
1) Because all of the money you put in reduces your taxable income every year and saves tax during your working years and
2) When you invest, all the investments grow and grow and don’t get taxed until you take money out.
That sounds like a good deal, get a tax write off and don’t pay tax on the growth. But, here’s the catch...at some point, the CRA wants their piece of the pie. They’re not going to just let you grow this and never pay any taxes on it. So, they force you to start taking money out when you turn 72 years of age. And it’s a percentage of the whole amount you’ve saved over the years, starting at about five percent of the whole ball of wax, so that can be a big income tax figure starting at age 72. If you have a million dollars saved in your RRSP, that’s $50,000 you must withdraw as income, whether you need it or not. Ouch.
TFSAs
The second type of retirement investment account is called a Tax Free Savings Account or TFSA. I don’t like the name of this plan, I think it’s misleading. I have had many people tell me they thought they could only invest in bank cash savings using this plan and that they could only open this plan at a bank. Not so. They should have named this account the Tax Free Investment Account, because you can invest in many different types of investments in this plan and you can open one with a financial advisor like myself, not just at a bank.
Here’s how these work. While you’re working, you pay tax on the income you earn. Then you take some of that money, after you’ve paid tax on it, and put it into a TFSA. Then you invest it, and like we mentioned in the RRSP, you don’t pay any tax on the money you earn on your investments in this account.
Now, here comes the difference with this plan. When it’s time to withdraw money from it, guess what? You pay no tax. You may have deposited money over the years and now it’s worth a million dollars and you say, whoo hoo, I’m pulling the whole million out and buying an island! Guess what? You won’t pay any tax on that million dollars! (Don’t do that, by the way.)
Which plan should you be paying into during the accumulation years, while you’re still working? The answer is going to be probably a little of both, but not necessarily at the same time.
If your company has any provision for matching RRSP or pension contributions, put your savings there first, because if you put in $100 and your employer puts in $100, that’s just like getting 100% return on your savings.
If you are in a higher tax bracket, you’ll save more, a lower tax bracket, you’ll save less. If you have an income of more than about $40,000, an RRSP is likely your best bet.
If you earn less than $40,000 a TFSA makes more sense to use as your savings vehicle. Once you start making more than $40,000, switch to an RRSP so you can divert more of your money away from the CRA and into your own pocket. Once you’ve maxed out the amount you can save there, start saving extra in a TFSA.
Sometimes I get the question, “Well, it would be nice if I had extra money to invest in an RRSP, but my employer keeps so much of my paycheque to pay the CRA in taxes, I don’t have enough left over to save. Then, I end up paying too much in taxes, and the whole thing is a vicious cycle.” The most efficient way to deal with that is to have your employer give you a bigger paycheque so you can save more and put it in your RRSP, right? How do you do that?
T1213 - Request to Reduce Tax Deductions at Source
There is a form called the T1213, Request to Reduce Tax Deductions at Source. If you have your tax preparer prepare this form after you’ve filed your taxes for the year, and send it into the CRA, that will allow your employer to not hold back as much in taxes going forward. So, you’ll get a bigger paycheque, you deposit the bigger amount into an RRSP and voilà, you divert money that used to go to the CRA into your RRSP account. Brilliant.
What’s Coming Next
Let’s recap. We talked about the different types of retirement investment accounts you can use as tools to build your retirement income mountain. We gave you a visual for how the accumulation and decumulation stages work. We talked about how you can feel more secure when it comes to managing your nest egg by using the waterfall method. And we talked about the specific features of retirement investment accounts and how they can help you reach your goals.
In future posts, we’ll cover other retirement income tools, such as real estate investing and dividend investing.
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