Recently I wrote a post about the benefits of RRSPs and showed a simple model comparing a dividend stock in a rrsp versus a non-registered account. In that model, the rrsp investment came out ahead.
Today I want to cover another scenario which involves an investment that has capital gains and no dividends. We’ll compare what happens if this investment is held inside an rrsp or in a non-registered account. In this case there is no “tax drag” from annual dividends.
One of my favourite readers, “Telly” pointed me to an excellent article that covers this very scenario on martingale’s site. This article explains exactly why the investment in the rrsp does better than outside the rrsp much better than I ever could. Basically he is saying that since the money in the non-registered account has already been taxed once (when it was earned), any taxes (interest, dividend or capital gains) are double taxation. The money in the rrsp has never been taxed so even though it’s taxed as income upon withdrawal, it comes out ahead of the non-registered investment because it is only taxed once.
In the attached spreadsheet I did a fairly simple model for this scenario. Martingale’s article uses the proper equations but I like to see the numbers year-by-year on a spreadsheet. In this case I used a $10,000 contribution into the rrsp and there is 40% tax deferred. In the non-reg account, there is only $6,000 because the 40% tax was paid upon earning it. After 20 years the investments in both accounts are sold while the investor is still working. This isn’t perfectly realistic but it keeps it simple.
At the end of 20 years the proceeds of the rrsp account are $27,966 and the non-registered account is $23,573. The rrsp account ended up with an after tax return of 8% and the non-reg got 6.3%. The rrsp account ended up with 19% more money than the non-registered account.
I think the moral of this story is that when considering the differences between rrsp accounts and non-registered accounts we have to remember that the non-registered money has already been taxed at the marginal tax rate of the investor. A lot of investors (including me) intuitively think that because the rrsp money is taxed at the marginal rate upon withdrawal that unless you are in a lower tax rate in retirement (when the money would be withdrawn), you might be better off having the money in a non-registered account. Clearly this is not the case.
As far as long term investments go (ie retirement money) you should put this money into an rrsp if possible and only invest outside the rrsp if there is no more room.
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