Benefits of RRSPs or Why I love RRSPs!

by Mike Holman

One of the benefits of an rrsp in that any capital gains or dividends are sheltered from tax as long as the money is in the rrsp. Investors who are doing a Derek Foster Maneuver or someone who just isn’t convinced of the benefits of an rrsp might be in the situation where they have unused rrsp room and securities outside the rrsp which are generating dividends and/or capital gains.

I’ve read in a number of books (including Four Pillars) that mention how the drag on performance from any kind of ongoing taxes such as dividend tax can be significant so I decided to see for myself how much effect dividend taxes have over 20 years.

To set up my spreadsheet I’m assuming that an investor has $100,000 of gross income which they can either put directly into an rrsp (no tax deducted at the source) which will result in a portfolio of $100k or they can choose to receive the $100k as income which will result in a portfolio of $60k after their 40% income taxes are paid.

I’ve made up a stock in which the purchases will be made. This stock will have 4% capital gains each year and pay a 4% dividend which will be reinvested. The dividend will be taxed at 20% in the taxable account.

At the end of 20 years, the investments will be sold in both portfolios, taxes will be paid and then the final amounts will determine which is the best way to invest. I’m assuming that when the securities are sold that the person is still working and will pay 40% income tax on the rrsp and will pay 20% on the capital gain in the taxable account (50% of capital gain * 40%). Note that neither situation is all that likely to occur in practice since good tax planning would dictate that you should wait until retirement to cash in the rrsp or sell the securities in the taxable account. However this method will allow us to isolate the effect of the tax on the dividends since all other factors will be equal.

In my spreadsheet, the first few columns are the rrsp account, this is a simple calculation – I basically add 4% cap gain + 4% div to the balance each year which results in total of $466,096 after 20 years. I’m assuming the dividend is paid at the end of each year. The income tax will be 40% of $466k which will leave $279,657 for the rrsp holder.

The taxable account calculation is a lot more complicated since I need to deduct the tax on the dividend each year (it gets paid from the dividend) as well as calculate the adjusted cost base of the investment (hopefully I’ve done this correctly) for the purpose of knowing how much capital gain there is. In this account the investor ends up with a total of $204,813 which is less than the rrsp account.

In summary the rrsp investor ends up with 37% more money at the end of 20 years which is quite significant. The investment rate of returns are 8.0% for the rrsp investor and 6.3% for the taxable account investor which is a big difference considering the only difference between the two scenarios is the tax on the dividend which doesn’t seem like a lot of money on an annual basis.

Given that the ending is not that realistic, I wouldn’t rely too much on these findings, however they certainly point to the conclusion that holding investments inside an rrsp is better than outside even if those securities have special tax considerations outside the rrsp such as dividend stocks. Active traders should also take note – they might be better off having their trading stocks inside their rrsp and their bonds outside their rrsps!

p.s. I’m working on a more complicated spreadsheet which will do the same scenario except that it will involve a more realistic scenario of collapsing the portfolio over five years. I’m not going to promise to finish it since it’s turning into a monster but I’ll see if I can at least figure out if the results will be different than the simplified scenario above.

 

 


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{ 22 comments… read them below or add one }

1 FourPillars

This sort of thing is one of my favourite topics.

It’s hard to analyze real life scenarios because there are so many factors involved.

Two scenarios I can think of where people should NOT contribute to an rrsp are:

1 – If they are low income earners ie $25k or less then the tax benefits aren’t really there for them and they will lose out on GIS when they turn 65. This is especially true if they are older and have a small or non-existent rrsp. Better never than late in that case.

2 – If you’re rrsp is big enough that you know you’re going probably get OAS clawback then that might be reason to scale back on contributions.

Mike

2 Canadian Capitalist

Good post. I am currently working on a different post with slightly different assumptions. I want to see how dividends affect the returns in a taxable account compared to only capital gains (all things being equal).

I played around with the assumptions a little bit. I assumed the initial portfolio for a non-RRSP investment is $72,000 (because I figured the investor paid his average tax rate his income, not the marginal rate). The RRSP scenario still comes out ahead.

3 FourPillars

I’ll look for that post.

I like doing these types of scenarios but the assumptions make all the difference.

I assume the non-reg investor paid the marginal rate since it’s unlikely that he/she would be able to put their entire net income into the non-reg investments.

Mike

4 telly

Great post. This is also one of my favourite topics and one I struggle with regularly. My husband and I both have lots of built up contribution room so we often wonder: do we max out the contributions, a little less, or maybe even a bit more?

We’ve decided that contributing enough to take us down a couple brackets is probably the best idea. If you know how much you need for retirement, just make sure all your contributions today are made above that bracket. That’s kind of our thinking…although who knows what the tax brackets will look like in retirement! I’ve read about people making contributions (30-40 years ago when taxes were much lower) that are now paying a higher rate withdrawing the RRSPs than they did when they got the deduction.

Mike, the only problem I have with your analysis is the $60k after tax. Even in Quebec (highest tax rate) $100k gross would give you $65,411 net. In Ontario it would be $70,797. I’m not sure how much of a difference it would make though…I’m too lazy to find out. 😉

5 FourPillars

Thanks for the comment Telly:

I should point out that the 100k is not the annual salary of the investor but rather an amount that they have to invest that is in the 40% tax bracket. It might have made more sense to use a smaller investment amount ie $10,000 to make it more realistic.

As far as your rrsp contributions go – you’re right – it’s not always that straight forward since it’s tied to the amount of tax being deferred on that particular contribution as well as what kind of retirement income your looking at which involves a lot of uncertain projections.

One thing I’ll mention which will be subject of a future post is that when you contribute to your rrsp, you defer tax at your marginal rate (or lower if you contribute enough) but you withdraw at the average tax rate.

For example: someone contributes $10k per year for 30 years and defers 40% tax each year. In retirement, even if they take out $100k per year which will put them in a higher marginal tax bracket than when they were working, the total amount of tax paid as a percentage is less (from your example – probably around 33%). So the idea that your marginal rate should be lower in retirement compared to when you are working in order to get a benefit from an rrsp is not accurate.

Mike

6 telly

Mike,
Thanks for setting me straight on that. I completely forgot the factor of withdrawing at an average rate. This makes the RRSP look even better. Hmmm…maybe it would be worth contributing enough to bring us down 3-4 brackets?

Just when I thought I had it all worked out! 😉

7 FourPillars

Telly: 3-4 brackets implies (to me) a really big one time contribution – maybe that can be spread out over a couple of years? Unless I’m assuming wrong of course.

I’m at a point where I don’t max my rrsp but we are going pretty heavy at the mortgage. Once I start maxing my rrsp and hopefully using up unused room I will definitely be trying to make sure my marginal rate doesn’t drop too much in any given year (if that makes sense).

Mike

8 telly

Mike,
In Ontario the mid to upper tax brackets are as follows:
37,179-62,487 – 31.15%
62,488-70,976 – 32.98%
70,977-73,622 – 35.39%
73,623-74,357 – 39.41%
74,358-120,887 – 43.41%
128.888 & up – 46.41%

The brackets are pretty narrow between $62k and $75k so for example if someone made $75k, it would only take a bit over $12k to go down 4 tax brackets! The return is higher in the upper tax brackets though of course.

Ernst & Young has some tax calculators that I really like.
http://www.ey.com/global/content.nsf/Canada/Tax_-_Calculators_-_Overview

The more I think about it, the more I think that RRSPs might be the better bet 99% of the time. Even someone earning $30k / yr would (in a 21.55% marginal tax bracket) that wanted to retire with the same income, their ave. tax at retirement would be 15.21%.

One more thing, clawback shouldn’t really concern many people. It only kicks in when a retiree has an income of >$60k. I don’t know about you guys, but I don’t plan to postpone retirement until my husband and I together earn $120k!

9 FourPillars

Thanks for the info Telly, I didn’t realize some of the brackets were so close together.

You’re right about the rrsps being good for most people. The other fact is the tax free dividends & interest, which is what I looked at in my spreadsheet. So even if someone only deferred say 20% tax on contribution and paid an average tax of 20% on withdrawal, they would still come out ahead because they didn’t pay any taxes along the way for divs & interest.

You’re right about the clawbacks, it’s only around age 71 when people sometimes run into problems because they have to withdraw about 8% of their rrsp (rif) that year – it’s pretty easy to plan around (hint – retiring early will take care of the problem).

Mike

10 moneygardener

One advantage of non-registered investments is access. No red tape or fees when you want to withdraw money expectedly or unexpectedly.

11 FourPillars

That’s true MG, although other than the withholding taxes (which were already paid on the non-reg) are there other fees for an rrsp withdrawal?

I think the biggest negative of withdrawing from the rrsp is that you lose that contribution room which in my mind is quite a price.

Mike

12 telly

We’re so scared into thinking RRSPs are untouchable but you’re right Mike, the only fees for RRSP withdrawal is the withholding tax.

The loss of contribution room would be the biggest downfall.

13 moneygardener

I’m not quite clear here.

Withholding tax when you cash out your RRSPs is 30% in Ontario. How were these already paid on non-registered investments?

In the case of non registered investments, tax treatment depends solely on your income. Capital gains and Canadian dividends are taxed at much better rates than 30%…

14 moneygardener

I just realized, that I assume you are reffering to the fact that the non-reg. investments were made with after tax dollars.

It is a complicated calculation, but in my opinion withdrawing from an RRSP for reasons other than home purchase or tuition will put you in a bad spot in many ways. For those reasons I prefer to do both, non registered as well as registered. One it for retirement and the other is for life before retirement.

15 FourPillars

MG – I agree that withdrawing from an rrsp is not a good thing to do, in fact I would say it should be done as a last resort.

I know people who took money out of their rrsps when they didn’t have enough money for something. If it’s a short term cash flow problem then borrowing the money would have been a better solution.

Mike

16 FourPillars

Telly – for what it’s worth – having a “fear” of withdrawing from our rrsps is not such a bad thing in my opinion. The reality is that there are a lot of investors who aren’t going to come close to maxing out their rrsp contribution room so for them, if the only “fee” for rrsp withdrawal is losing rrsp contribution room then they would be a lot more tempted to use that money for nefarious purposes such as plasma tvs etc.

Mike

17 telly

MG: Withholding is only 10% for up to $5k, 10% from $5-20k and 30% above that. But withholding is really irrelevant, the important factor is your average tax rate at withdrawal. Like you, I don’t plan to use my RRSP money for anything but retirement but there coud be situations where it might make sense (beyond home & education) to withdraw from an RRSP, but again the bigger issue is loss of contribution room.

An example would be that if say a couple had a child but could not afford to make ends meet if the mother took a year maternity leave. Because her income would be very low in that year, she could withdraw from an RRSP to supplement and pay very little income tax (a much lower rate than when she contributed).

I’m not saying this a good plan but if it means the difference between being able to stay home to care for the child or having to go back to work, it might make sense.

But I agree Mike, for the most part, it is a good thing we’re scared. If it wasn’t for the withholding factor, I think a lot more people would be dipping. I almost think the withholding should be higher!

18 FourPillars

Telly – u described the exact situation I have thought of. My wife has lots of contribution room (and isn’t working) and it has occurred to me that we could take money out of her rrsp and contribute into mine. I’ve decided not to do it since we will lose the spousal tax credit. It’s not all that likely that all her contribution room will get used, so it’s not as valuable.

Mike

19 telly

I too, have tons of contribution room and doubt I will find the time to use it all up before I retire :), especially if I continue to work in the US.

I guess it’s not always cut and dry. It’s good to know you’ve done the calculations for your situation and detemrined what makes the most sense.

And thanks again for the great post, though we do max out my husband’s RRSP, I needed a reminder of the importance of them.

20 Lulu

When is it appropriate to invest in both RRSP’s and non RRSP’s, or should one just stick to RRSP’s?

21 Lulu

And if contributing to both is a good idea, what amount should be allocated to each?

22 Four Pillars

Lulu – it really depends on the individual situation.

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