By Shawn Allen, Contributing Editor
Canadians have been contributing less to RRSPs in recent years. In part, this is due to the introduction of the Tax-Free Savings Account (TFSA). Disturbingly, it is also due in part to inaccurate “bad press” that RRSPs have received.
Yes, it’s true! RRSPs too have been the victim of “fake news”. Much of this bad press is spread by well-intentioned but unqualified and ill-informed people posting on various Internet sites. This is unfortunate because RRSPs remain the best retirement savings vehicle for most (although not all) employed Canadians. I will provide the math below.
Those contributing to the bad press often describe RRSPs as a mere tax deferral system rather than a tax reduction system. Those with more extreme views call RRSPs a “tax bomb” waiting to explode. These views are false and result from confusion. Far from being a “tax bomb”, an RRSP can usually result in net tax-free growth after properly considering both the initial income tax refund and the taxes paid upon withdrawal.
Why the confusion?
Here’s how the confusion arises:
Investments and savings in a TFSA, of course, grow completely tax-free. $100,000 in a TFSA can be taken out and spent at any time with no income tax payable.
Investments and savings in a taxable investment account accrue tax on interest, dividends, and realized capital gains and the tax must be paid each year. But $100,000 in a taxable investment account can also be withdrawn and spent at any time and the only additional tax payable would be on any capital gains that had to be triggered and realized in order to convert the investments to cash.
Investments and savings in an RRSP grow completely tax-free as long as there are no withdrawals from the account. But removing $100,000, in one year, from an RRSP would result in roughly a 40% to 54% tax hit, depending on your marginal income tax bracket, which increases with income and varies somewhat by province. (Your marginal income tax rate is the rate applicable to each additional dollar of income and is higher than your average income tax rate.)
Even if withdrawals are kept much smaller and spread over many years, most RRSP investors will face taxes upon withdrawal of at least 20%, and 30% to 40% is probably more typical. Those in the highest bracket could face tax rates of 54% on RRSP withdrawals. RRSP withdrawals are taxed not only on the gains that the investments have made but on the removal of the original contributed amounts as well.
Based on the above, the argument is made that RRSPs are clearly tax traps and should be avoided. But the full math tells a far different story as the following example illustrates.
Imagine you earn an additional $10,000 and are in a 40% marginal income tax bracket. You will net $6,000 after tax, which you can choose to spend or to save. If that money is placed in a TFSA and grows at 8% annually then you will end up with $60,000 after 30 years. You will pay no tax on the $54,000 in growth.
Alternatively, you could invest $10,000 in an RRSP. This would be your own $6,000 plus a borrowed $4,000, which you will shortly repay with the 40% tax deduction that you will qualify for. If that money grows at the same 8% you will end up with $100,000 after 30 years. If you then face a hefty 40% marginal tax rate upon withdrawal you would net $60,000.
Notice that your net cost was $6,000 in both cases. In both cases, it was the same $6,000 in after-tax funds that were no longer available for spending. And in both cases your after-tax result in the end was $60,000. Your gain was $54,000 in both cases. If your net $6,000 in the RRSP grew to the same amount after tax as it did in the TFSA then the inescapable conclusion is that your $6,000 in the RRSP also grew completely tax free despite the 40% taxes paid on the withdrawal! Your $6,000 did not merely grow on a tax-deferred basis, it grew tax free!
How can this be? Well, in substance, in the example above the initial 40% tax refund effectively funded 40% of the RRSP or $4,000 of the original $10,000 contribution. Think of that as the “taxman’s” (permanent) share of “your” RRSP. The taxman’s 40% share subsequently grew at the same rate as your 60% share and fully funded the 40% tax upon withdrawal.
And, better yet, if your marginal tax rate upon withdrawal is lower than the marginal tax rate at which you contributed and obtained a refund, then the taxman’s share of your RRSP will more than fully fund the taxes due and your own net contribution to the RRSP will have grown to a net after-tax amount that is even larger than would occur in the TFSA. That is effectively a negative tax rate on the growth in your own net contribution to your RRSP.
The big mistake that RRSP investors make is to consider their RRSP to be worth 100 cents on the dollar. It never was. It only cost them, say, 60 cents on the dollar after considering the refund. It will only ever be worth 60 to 80 cents on the dollar depending on the marginal tax rate applicable to withdrawals.
On a properly constructed net worth statement it is simply incorrect to value an RRSP account at 100 cents on the dollar. It should be shown at a reduced value to account for the approximate percentage that will be lost to income taxes upon withdrawal. Sadly, those who count their RRSP account value at 100 cents on the dollar are poorer than they thought.
Not free money
If you contribute $10,000 to an RRSP and get a $4,000 refund, that refund is not “free money” and your net worth does not increase by $4,000, or at all. In substance, you have contributed a net $6,000 to the RRSP and the taxman has contributed $4,000. The taxman is, in effect, a permanent partner in “your” RRSP.
Upon withdrawal, the taxman will take back a share that is based on your marginal income tax rate. In most cases this take back rate or percentage will be lower than the rate or percentage that the taxman, in effect, originally contributed to your RRSP. Having a partner that contributes 40% to a fund that grows tax-free and who usually takes back somewhat less than 40% still leaves you with access to tax-free growth on your 60% share of the RRSP and, in that case, even lets you keep some of your partner’s 40% share.
If you forget that that the taxman originally funded about 40% of “your” RRSP then paying say 30% or 40% taxes upon withdrawal seems very harsh indeed. But if you consider that the deal is that your (say) 60% net contribution to the RRSP has grown completely tax free and that that all the taxman is doing is taking back his 40% share (and often he takes back less than that) then you will realize that investing within an RRSP has been very beneficial indeed.
Despite some bad press and fake news, RRSP investing is very beneficial and Gordon Pape has written a book called RRSPs: The Ultimate Wealth Builder if you want to know more. It’s available on Amazon.
Most people earning income from employment and who are in a marginal income tax bracket of at least 30% should absolutely contribute to an RRSP, particularly if they have already maximized their Tax-Free Savings Accounts.
Do not listen to uninformed people who refer to RRSPs as income tax traps.
As painful as it is, begin to think of your RRSP as having a value of 60 to 80 cents on the dollar. Ease the pain by remembering that you only contributed about 60 to 70 cents on the dollar and your tax refund effectively contributed the remainder.
Be wary of suggestions to cash out your RRSP investments early to avoid income taxes. That can make sense in rare cases where people face a period of extremely low income (and therefore very low marginal tax rates) and especially if the withdrawals are used to fund TFSA contributions. But in most cases it would not be a wise move. Be especially wary of any financial advisor who advises you to cash out an RRSP that is not invested with him or her in order to make investments that the advisor will then earn fees from.