In Defense of the Much Maligned RRSP

In Defense of the Much Maligned RRSP

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We are approaching the Registered Retirement Savings Plan (RRSP) deadline but deadline or not, I suspect most readers will have contribution room available, which can be found on your annual income tax “Notice of Assessment.” Many Canadians have tossed the RRSP into the trash bin, favouring the TFSA. I certainly agree with favouring the TFSA, especially for lower income Canadians, but wanted to make a case for also supporting the RRSP.

There are three key advantages of the RRSP over the TFSA. Firstly, contributions are tax-deductible the year they are made, creating an immediate tax benefit. Contributions can be made the first two months of the current year and applied back to the previous year, which is why the deadline is usually February 28th or March 1st. Secondly, there are no dividend withholding taxes on US stocks. Thirdly, and a much less know benefit, is that retirement funds might be secure from creditors in the case of bankruptcy. There are some caveats around this benefit which vary from province to province, so please check with your accountant on its pertinence in your individual case. One caveat is that if a large lump sum payment is made into an RRSP just prior to declaration of bankruptcy, it is unlikely to be protected for obvious reasons.

This third reason is why entrepreneurs should seriously consider an RRSP, especially starting out when finances of a business are less stable. Nobody starts a business with the intent of going broke but it frequently occurs.

The key disadvantage of the RRSP is that when it’s collapsed, the money withdrawn is taxable. This is why so many have turned negative on the program even though many will be in a lower or equal tax bracket upon retirement than when working. Entrepreneurs, who tend to pay themselves poorly while operating their business but may retire wealthy when they sell, could be in a higher tax bracket upon retirement. Let me demonstrate, using the “Rule of 72,” how even if paying higher taxes upon retirement, an RRSP could still be financially beneficial.

Compounding builds faster when tax-free

For this scenario, let’s use a 40-year career length time period, nine percent annual returns which is very doable with stocks, a 33.33% marginal tax rate when the contribution is made, and a 50% tax rate upon retirement.  The money would double every eight years, leading to five doubles. A $1000 contribution would compound to $32,000, and applying a 50% tax rate upon withdrawal would leave $16,000 after tax. However, you also get a $333.33 tax refund. Investing this at the same rate of return would yield six percent after tax, doubling every 12 years or 3.33 times in the 40 years. Therefore the $333.33 refund becomes $3,547, added to $16,000 becomes $19,547.

Simply investing $1000 outside an RRSP, achieving nine percent before tax or six percent after-tax would yield $10,640, which is considerably less than $19,547.

Dividend or capital gains investment income is generally taxed at a lower rate than straight income or interest income. If we used a marginal tax rate on investment income of half the 33.33% for 40 years, the money outside an RRSP would become $18,720.  The $1,000 inside an RRSP taxed at 50% upon withdrawal, with a $333.33 tax refund invested outside the RRSP would total $22,240, still considerably more than investing entirely outside an RRSP.  Please keep in mind this advantage exists despite the unlikely scenario of paying considerably more tax upon retirement than when working.

A more likely scenario would be that the tax rate is the same going in and coming out. Let’s see how it works out with a 50% marginal tax rate when the contribution is made and when withdrawn, with a 25% tax rate on investment returns outside an RRSP. The money outside the RRSP yielding 9% with a 25% tax rate would effectively yield 6.75%, taking 10.7 years to double and doubling 3.7 times in the 40 years. Therefore the $1000 outside an RRSP would become $13,600.The $1000 deposited inside the RRSP would still become $32,000, getting cut in half upon withdrawal to $16,000.The $500 tax refund would become $6,800 for a total of $22,800. Way more than $13,600! These examples are simplifications but should clearly demonstrate the advantage of compounding inside a tax-advantage RRSP account.

In conclusion the advantages of investing inside an RRSP are better:

  • The longer the time horizon.
  • The higher the rates of returns.
  • The higher your current marginal tax rate.
  • The lower your retirement marginal tax rate.
  • In the unfortunate event of bankruptcy.

I hope this article equips you to use the “Rule of 72” to think through scenarios for your own specific circumstances, keeping in mind it is an approximation calculation. It was not my intent to get into all the RRSP details, but simply paint a picture of why RRSPs should be considered as part of a financial plan.

 

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