Does it pay to buy RRSPs?

Every year at this time, I get a barrage of questions about whether it makes sense to still buy RRSPs? The first thing to understand is that the answer may be different for everyone. We all try to apply universal advice to our unique situations.

When trying to determine whether RRSPs are advantageous, the first step is to know your marginal tax rate. Here in Alberta, the tax rates for 2002 (provincial and federal combined) were:

 2002 Tax rate 2003 \$7931 to \$31,675 26% \$8169 to \$32,625 \$31,676 to \$63,353 32% \$32,626 to \$65,254 \$63,354 to \$103,000 36% \$65,255 to \$106,090 \$103,000 and up 39% \$106,091 and up

The reason this is the first step in the decision to buy RRSPs is that your marginal tax rate determines the immediate benefit for the RRSP. For example, if I made \$25,000 last year, my wife made \$45,000, and you made \$75,000 and we each decided to invest \$1000 into the RRSP, I would save \$260, my wife would save \$320 and you would save \$360 in tax. Despite investing the same \$1000 we all get different tax benefits depending on our marginal tax rate.

What are you investing in?

To complicate things a little more, we need to determine what you are going to invest in. Different investments generate different types of investment income. Why is this important? These different types of investment incomes have different tax treatments. Interest income is fully taxed, dividends and capital gains are both tax-preferred. Depending on your tax rate, if you are investing in equity investments that generate capital gains, you will not enjoy the benefits of tax-deferred income as much as someone who invests in fixed-income investments that generate interest income.

How long before you draw money out of an RRSP?

Next, you need to take a look at how long you will leave the money inside the RRSP before you start to take money out of the RRSP. Once again, the idea is to determine the value of tax-deferred income inside the RRSP. The longer you plan to leave the money in the RRSP, the more likely you are to benefit from tax-deferred growth inside the RRSP.

What will your marginal tax rate be when the money comes out?

The last thing to consider and one of the most difficult is to try to see what your marginal tax rate will be when it comes time to take the money out of the RRSP. Obviously, the ideal situation is to invest the money when you are in the highest marginal tax rate and then take the money out when you are in the lowest marginal tax rate. In this example, you would get a 39% tax benefit when the money goes in and then pay 26% when the money comes out. On the other hand, you would be doing yourself a disservice if you put money in while you are in the lowest tax bracket and then taking it out in a higher tax bracket. While this is rare, I do see it happen from time to time.

As you can see, you can complicate the decision as much as you want. Generally speaking, most investors still benefit from the tremendous tax deduction at the time of contribution. The reality is that the outcome really depends on what assumptions you use: your marginal tax rate at the time of deposit, your marginal tax rate at the time of withdrawal, amount of capital gains realized annually, time horizon, investment selection outside the RRSP, rate of return assumptions, etc.

In order to properly assess the merits of RRSPs in your financial situation, it is important to use realistic assumptions about your financial future.

Don’t confuse investing for retirement and investing in RRSPs.

Regardless of the decision to buy RRSPs or not, it does not preclude you from investing at all. If RRSPs do not make sense for you then don’t assume that you do not need to invest at all. Do something else with the money you were going to invest in. Sometimes I see people using the RRSP argument as an excuse not to invest at all.

This year there have been studies that show that RRSP contributions are likely to drop. This concerns me at a time when self-funding your retirement becomes more important than ever. Good luck with this RRSP season.