With another February upon us, Canadians are reminded by their financial institutions about the deadline to make a contribution to their RRSP for a tax deduction to go against last year’s income. Many people have been encouraged to contribute to an RRSP as soon as they started earning an income and generating RRSP contribution room, and many others have unused contribution room and wonder if they should focus on using up that contribution room before they retire.
Most people who want to save for their retirement may not have enough available money to use up all their RRSP and TFSA contribution room, which leads to the question of which one should they contribute to. To help decide which account is the best to save for retirement in, it is important to understand how the tax deferral mechanism of RRSP contributions work, and how that tax deferral could potentially end up working against you in the future.
In its most basic form, the tax deferral function of an RRSP works as follows:
The general strategy is to contribute to an RRSP when you are in your working years and in a higher tax bracket, and to withdraw the money when you are retired and earning less, and therefore in a lower tax bracket. You then theoretically get a bigger tax refund on your contributions than you will pay in taxes when you take the money out. Seems to make sense, right?
Unfortunately, it’s not quite as simple as that in practice. One of the first truths about RRSPs is the growth within the plan is ultimately taxable, but it is just deferred until it is withdrawn. This differs from TFSAs where growth within the plan is not taxable, even when it is withdrawn. There are a few articles on the internet that argue the growth within the RRSP is effectively tax-free, as long as your tax rate is the same in the year of the withdrawal as it was in the year when you made the contribution ( https://financialpost.com/personal-finance/taxes/the-five-biggest-rrsp-myths-that-canadians-cant-stop-repeating ).
The calculations involved in proving this require the RRSP contribution to be made from “pre-tax” income, while the TFSA contribution is made from after-tax income, and potentially 30-40% less than the amount contributed to the RRSP. As much as we would all like to get paid without taxes being deducted, this scenario simply does not apply to the real-life experience of most Canadians, but it does confirm my second truth about RRSPs. But before getting to that, let’s definitively prove that growth in an RRSP is eventually taxable. If you contribute $5000 to an RRSP and if that $5000 grows to $10,000 over time, when you take that $10,000 out of the RRSP or RRIF, the full $10,00 is fully taxable as income regardless of what your tax bracket is at that time, likely leaving you with much less than $10,000 after taxes. So, you are taxed on the initial $5000 you contributed, plus the $5000 in growth, meaning the growth in the account is not at all tax-free.
This leads to the second truth about RRSPs, which is if you get a tax refund resulting from your RRSP contribution, you need to reinvest it, otherwise you would likely have been better off contributing to a TFSA. Without presenting all the math to prove this, it is actually a fairly easy concept to understand. If one person contributes $5000 to a TFSA and another contributes $5000 to an RRSP (and doesn’t reinvest their tax refund), and both accounts have the exact same rate of return, they’ll both grow to be the same amount over time, let’s say to $20,000. When that $20,000 is taken out of the TFSA, none of it is taxable as income, and you keep all $20,000. When the $20,000 is taken out of the RRSP (or RRIF), it is taxable as income, let’s assume at 30%, leaving $14,000 after tax. So, in this instance, the TFSA investor comes out ahead of the RRSP investor that spent their refund, after the RRSP withdrawal is taxed. Now if that RRSP investor reinvested their tax refund (30% or $1500 for example), they’ll be starting with a larger amount in their RRSP and that will grow to a larger amount over the same period of time as the money in the TFSA. Once that money is withdrawn and taxed, and even if it is taxed in a lower tax bracket than what the investor was in when they made the contribution, they’ll end up with around the same after-tax amount as the TFSA investor. Only in instances where the RRSP contribution is made “pre-tax”, or the tax refund is re-invested and you start with a higher amount in the RRSP than in the TFSA, will both accounts end up with a similar amount after tax when the money is withdrawn from the RRSP or RRIF.
If that tax refund is not re-invested, and all other variables are equal, the TFSA investor will nearly always end up with more money after tax, unless the RRSP investor is somehow in a 0% tax bracket. A more in-depth comparison of various scenarios of RRSP and TFSA contributions and withdrawals is available in the following article, https://www.cibc.com/content/dam/personal_banking/advice_centre/tax-savings/rrsp-versus-tfsa-report-en.pdf .
The next truth about RRSPs is even if you are in a lower tax bracket when you withdraw from your RRSP or RRIF, you will likely be paying a higher dollar amount in taxes for taking all of that money out than you received in tax refunds for making the original RRSP contributions. While the general RRSP strategy is to be in a lower tax bracket when you are retired and withdrawing the money than you were in while you were working and making the RRSP contributions, this does not necessarily mean you will pay a smaller dollar amount of taxes when withdrawing the money than you received in tax refunds for contributing the money. To illustrate that, let’s use of the example of someone who is in a 38% tax bracket when they contribute to their RRSP, and a 26% tax bracket when they withdraw that money. Let’s also assume they invested $10,000 to their RRSP, then left it in the RRSP for 20 years earning an average return of 6%, which would grow to approximately $32,000. When that person contributed their $10,000 while in the 38% tax bracket, they should have received a tax refund of roughly $3,800. Now, when they take out that $32,000, even if it is in a much lower tax bracket of 26% (and even if withdrawn over several years, but still at a 26% tax rate each year), they will owe approximately $8,300 in taxes, which is more than twice what they received in tax refunds for making the initial contribution. This further goes to prove the first truth about RRSPs, that growth in the RRSP is fully taxable, and it also may make you wonder if RRSPs are a better deal for you, or for the CRA.
While these truths about RRSPs may make it seem as though I am not a fan of RRSPs, or that I think TFSAs are superior to RRSPs, that is not necessarily the case. It does lead to my final truth about RRSPs though, which is RRSPs can offer a great tax-deferral strategy for people in very specific situations, but may not offer much benefit for a larger portion of the population. If I could describe the ideal candidate that should contribute to an RRSP, it would be someone with a high income (likely close to or above $100,000 per year), and that has no pension. A person in this situation would benefit the most from making RRSP contributions as they are in the higher tax brackets to claim the income deduction against, and would likely have little other income in retirement, resulting in them paying taxes at a much lower rate compared to someone with a good pension. For someone whose income puts them in the lower tax brackets while they are working, especially if they eventually retire with a pension, there might not be too much of difference in the tax brackets between when they were contributing to the RRSP and when they were withdrawing from them. That in turn means the tax deferral strategy does not benefit them nearly as much, and could actually work against them once tax on the growth of the money is factored in.
So, as we near the RRSP contribution deadline, please keep these truths about RRSPs in mind, and consult with a qualified financial advisor if you need help determining what makes the most sense for you. If you would like to speak to me about your individual situation, I would be happy to answer any questions you may have, and you can contact me at Dennis.Rubeniuk@Endeavourwealth.ca or 204-318-2663.
Dennis Rubeniuk, Investment Advisor
Dennis Rubeniuk is an Investment Advisor at Endeavour Wealth Management with iA Private Wealth Inc, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.
This information has been prepared by Dennis Rubeniuk who is an Investment Advisor for iA Private Wealth Inc. and does not necessarily reflect the opinion of iA Private Wealth. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.
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