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:
Assuming 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)