The great RRSP debates
RRSPs are perceived to be one of the best savings vehicles for retirement because of some of the tax benefits of the RRSPs. That being said, there are more and more people are questioning the validity of RRSPs and whether they really make sense? Given many alternative uses for money, I outline three great debates of RRSPs.
Debate #1: RRSP vs mortgage
Generally speaking, either financial strategy is a good choice. It is better than spending the money on things that have no inherent financial value. It is also better than “investing” (I use that term loosely) in depreciable assets like cars.
Let’s compare the financial benefit of the two alternatives. First, let’s look at the mortgage. Let’s assume that mortgage rates are 6%. You might think that paying down the mortgage means that you forego paying 6% in the future and therefore the mortgage paydown has a financial benefit of 6%. Most mortgages are not tax-deductible thus you must earn more than a dollar to pay down a dollar of debt. In fact, you probably need to earn about $1.50 to pay down a dollar of debt. Thus paying down the mortgage has a pre-tax equivalent of 8.8% (6%/(1-32%)). Remember the higher the interest rate on the mortgage, the more attractive it is to pay down the mortgage.
Now let’s look at the RRSP. Even if you are in the lowest marginal tax rate, you will save around 25% in tax* (combined federal and provincial). In a higher tax bracket, the RRSP might save you as much as 48% in tax savings. The bottom line is when you compare the two; a dollar put toward the mortgage saves you the equivalent of 8.8% while the RRSP saves you at least 25% in tax. Given the choice, I would take a 25% saving over a 10% saving.
One thing to keep in perspective is that this example is overly simplistic because you will have to pay tax somewhere down the road when you take the money out of the RRSP but you also get the benefit of tax-deferred compounding as long as the money stays in the RRSP.
One thought is doing both might make the most sense. You can do this by making the RRSP contribution first and then use the tax savings or refund to pay down the mortgage.
For example, let’s assume I have $10,000 and I am in a 30% marginal tax rate. By contributing to the RRSP, I should save $3,000 in taxes and potentially get that in a refund. Once I get the refund, I should then take the $3,000 and pay down the mortgage. I have created $13,000 of use out of $10,000.
*Tax rates will vary from province to province.
Debate #2: RRSP vs non-RRSP
When it comes to investment income, capital gains and dividends have a much better tax treatment than interest. However, is it attractive enough to ignore the benefits of the RRSP?
The two key advantages to the RRSP are (a) the tax deduction and (b) the tax-deferred growth. These two benefits make the RRSP one of the most attractive financial planning vehicles available to Canadians. However, when you pull the money out of the RRSP, you will get taxed. Every dollar you pull out of an RRSP regardless of whether it is capital gains, interest, dividends or your original invested capital gets taxed at your current marginal tax rate.
On the other hand, the non-RRSP is taxed only on growth, dividends, and interest. Withdrawing your capital is not subject to taxation. Astute investors will look for investments that generate capital gains and dividends because of the preferred tax treatment.
So what’s the best solution? It depends on your personal situation but most people will still benefit from the RRSP. Let’s take a look at some key factors:
- Investing behavior. If you are a really active investor and you like to buy and sell, trade or rebalance a portfolio frequently, you may be better off with the RRSP. Outside the RRSP, every time you trade, you create a potential tax disposition. The tax-deferred growth in the RRSP may be in your best interest.
- Time horizon. Generally speaking, it is rare to see investors hold the same investment for twenty to thirty years (or even ten years). The longer the time horizon, the more you will benefit from tax-deferred compounding in the RRSP. It has been said that compound interest is the eighth wonder of the world.
- Marginal tax rates. It is important to understand what tax rate you are in at the time of the deposit but also know your tax rate at the time of the withdrawal. This will be easier to estimate the closer you are to retirement. The ideal situation is if you take the money out in a lower tax bracket than when you put the money in. In that case, RRSPs will always make sense
- Investment flexibility and freedom. RRSPs have some investment restrictions. Outside the RRSP, there are little to no restrictions on what you can do. While there is still lots of investment flexibility inside the RRSP, there is more outside the RRSP.
- Overall financial picture. Believe it or not, there is such a thing as having too many RRSPs. In some cases, your RRSPs may be so significant that your future income from the RRSP will push you into a higher tax bracket. In other situations, deferral of the RRSP can create a very significant tax liability down the road.
Remember everyone’s situation is different and you must take the time to assess your personal situation to see what path is best for you. These comments are general statements that may not apply to everyone.
Debate #3: RRSP vs TFSA
In the 2008 federal Budget, Finance Minister Jim Flaherty announced what he considers will be historical significance in introducing Tax-Free Savings Accounts (TFSA). Previous to the introduction of TFSAs, saving money could be done either in an RRSP or a non-registered savings account. The newly announced TSFA is a mix between an RRSP and a non-registered account.
RRSPs are attractive because you get an immediate tax deduction for the contribution and any investment earnings are tax-sheltered as long as the money stays in the RRSP. On the other hand, the downside of RRSPs occurs when you take money out because you then have to pay the tax.
With TFSAs, you do not get a deduction when you put the money in but you also don’t have to pay tax when you take the money out. Similar to the RRSP, you do not have to pay tax on any investment earnings in the TFSA giving you the benefit of tax-sheltered investment growth.
With the TFSA, on a $5000 contribution, you will save $50 to $80 in the first year of contribution from tax-sheltered growth. Critics of TFSAs suggest that’s not enough benefit to entice people to save and while that may be true, how would you feel if you found $50 on the ground today. I bet it would make your day. I’m of the opinion that any amount of money saved from taxes is in your best interest!
When you compare the benefit of the TFSA with what you would get if you invested in the RRSP, the TFSA may not be as attractive because the RRSP would give you $1250 to $2000 in tax savings from the initial tax deduction.
However, you can’t properly compare TFSA with the RRSP by just looking at the tax savings going into the plans. You also have to look into the future when the money comes out of the plans. With the RRSP any withdrawal is fully taxable. That means a withdrawal of $1000 might only net you $600 to $750 after tax depending on your marginal tax rate. With the TFSA if you take out $1000, you get the full $1000.
The bottom line is RRSPs still make sense if you are saving long term for retirement and your income at the time of withdrawal is in a lower tax bracket than your income at the time of contribution into the RRSP. Here’s a great rule of thumb to follow:
- If your marginal tax rate at the time of contribution is greater than your marginal tax rate and the time of withdrawal, then RRSPs have the advantage.
- If your marginal tax rate at the time of contribution is less than your marginal tax rate and the time of withdrawal, then TFSAs have the advantage.
- If your marginal tax rate at the time of contribution is equal to your marginal tax rate and the time of withdrawal, then neither has the advantage.
Maybe the best thing to do is do both the RRSP and the TFSA
Jim’s three step RRSP/TFSA rule of thumb is right on the money! The same rule of thumb applies to the RRSP/Mortgage issue, as the tax free compounding TFSA benefit is equal to the mortgage savings benefit, assuming that the rates are the same.
Jim misses the boat however, in his contention that the the RRSP tax refund is of some value, and that you “have created $13,000 of use out of $10,000”. The reality is, the $10,000 that you have in your RRSP only actually cost you $7,000 out of pocket due to the $3,000 tax refund. The second, less understood reality is, the $10,000 of RRSP fund is only WORTH $7,000, as that is what you will have left if you withdraw the ten and pay three in tax.
You still only have $10,000 of useable funds, the $3,000 tax refund, plus the $7,000 net RRSP value.
Consider that you might just as well put $7,000 in your TFSA. You do not have to wait for your $3,000 refund, as you did not have to put out the extra money to “buy” the tax refund in the first place, as you did with the RRSP. Say several years down the road, your $10,000 RRSP has tripled to $30,000. Invested in the same manner, your $7,000 TFSA would be at $21,000. If you need to spend it, your TFSA is worth $21,000 in real dollars, whereas your RRSP is worth $30,000 less $9,000 of tax equals $21,000 in real dollars. So where is the RRSP advantage? The so called RRSP related tax “refund” is an illusion.
Thanks for stopping by Paul. I like the way you think.
The RRSPs can still be advantageous if you take the money out at a lower tax rate than when you put it in. In that case, the RRSP has the edge and is not really a complete illusion. Personally, I still by RRSPs myself on this basis.
It’s not a perfect apples to apples comparison. The $10,000 RRSP contribution requires $10,000 of cashflow and the $3000 is still inside the RRSP growing tax deferred. Also the TFSA limits might be lower than the RRSP limits so it depends on how much money you have to contribute in the first place.
Anyhow, I really appreciate the comments and readers will need to do their own planning to make sure they are doing the right thing.
Agreed that the RRSP has the edge if withdrawal is at a lower tax bracket…… but consider that 65% of Canadians are in the lowest tax bracket now, with no hope for a lower tax bracket at retirement. In fact the GIS and OAS clawbacks could put many retirees into a much higher effective tax bracket at retirement. See https://www.yourmoneymatters-canada.ca/income-tax-basics/tax-on-seniors/ for more discussion of seniors tax rates.
Hi Jim, my husband and I love your articles. Keep up the good work!
I have a question about withdrawing from RRSP and non registered savings in retirement. When one retire very early, say in his forties, doesn’t it make sense to empty out his RRSP evenly before starting to collect CPP and OAS? That way, he ends up paying less tax overall and won’t risk OAS clawback.
I’ve noticed in many retirement income calculations that suggest withdrawing from non registered accounts first before RRSP.
What are your thoughts on this?
Thanks for the kind words. It’s really hard to answer your question because there are so many variables that go into this. The key is to do some income projections and understand your marginal tax rates now, at 40, 60 and 65. There’s no question that taking money out of RRSPs in a low marginal tax bracket is, generally, a smart strategy.
we use a spousal RRSP in our situation, and keep some funds in a TFSA as well. My concern is if one of us passes on before withdrawing from the RRSP and the tax consequences.