Benefits of RRSPs Part 2

by Mike Holman

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at the marginal rate upon withdrawal that unless you are in a lower tax rate in retirement (when the money would be withdrawn), you might be better off having the money in a non-registered account.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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{ 17 comments… read them below or add one }

1 Rog

Definitely watch your RRSP limits. CRA imposes big fines if you go over. I have friends who got bit by this, and they are having a devil of a time convincing CRA’s computers that they paid the fine. They keep getting computer-printed notices in the mail, and the fines get bigger and bigger.

2 moneygardener

Once again I’ll echo my argument that what I don’t like about RRSP’s is that they are for retirement, which for most people means when you are over 60 years of age.

3 FourPillars

Rog – that’s a good point.

MG – RRSPs are just a financial tool.

I think if you have money that you are not going to be touching for a long time then RRSPs are probably the best bet. For any other situation they might or might not be the right way to go. Certainly anything short term should be kept out of the rrsp.

“The right tool for the right job!”

Mike

4 telly

MG, I think most of us that attempt to max out RRSPs plan to retire much earlier than 60 but I can see your point.

For me personally, I’ve yet to come across a situation where I wish I hadn’t poured so much into an RRSP but I guess that’s not the case for everyone.

5 FourPillars

I think proper planning is the key.

For example, if you live in a 2 bedroom starter house and plan to have 4 kids then you kind of have to know you’ll be wanting a bigger house at some point. In that case maybe keeping money out of the rrsp makes more sense.

Mike

6 telly

Mike, are you trying to tell me something? 😉

Actually, we don’t plan to stay in our house forever but our plan is to not move until we have enough principal in our current home to put 20% down on the next home (assuming no gain in our home but average gains for housing in general). Considering we make substantial pre-payments, it should work out for us. And if not, and we happen to breed like rabbits, we can make the kids share rooms. 🙂 After all, I did for many, many years!

7 home in boca

Mike,

I agree that an RSP should be one of the foundations of Financial Planning. I have been making the maximum contribution for the past 10 years to catch up and am now in a nice position to retire in 10 yrs.

BTW I wanted to let you know that since I read The Four Pillars of Investing, I have shifted all my RSP Equity holdings to Index Funds, and have significantly lowered my MER expenses. It feels great!

8 FourPillars

Boca – glad you enjoyed the book. I did the same thing and coverted my rsp to ETFs recently.

Mike

9 FourPillars

Telly – no I wasn’t referring to you…

I agree – nothing wrong with sharing rooms.

Mike

10 telly

I know you weren’t referring to me but you made a good point and for those of us that are considering that, we need to plan ahead.

BTW, thanks for referring to me a one of your favourite readers. I’m flattered. 🙂

11 moneygardener

My situation:

Age of my wife and I = 28

Future need for capital = (anywhere from 10 – 30 years away or more) – I want it available at all times after 10 years.

Retirment plans – No plans for early retirement.

Do you agree that non-registered makes sense for the money over and above retirement needs?

12 moneygardener

Another point I have is that I do not think it is correct to say that money invested in a non registered account is ‘double taxed’ upon withdrawl. The principle is actually only taxed once, and the growth is taxed once. The same dollar is never taxed twice. Also, capital gains and dividend taxes are much less than income taxes as you know. I know RRSP will still come out ahead but I think using the term ‘double tax’ is inaccurate.

13 telly

MG,

If you want the money available at all times after 10 years and plan to continue working (with no substantial decrease in income) than you’re probably right to use non-registered investments beyond what you’ll need for retirement. At the same time then, you’ll likely want to start building a portion of your non-registered savings in fixed income, especially as you get closer to the 10 year mark. At least that would be my take.

14 moneygardener

I see your point Telly. Secure some capital for mid term use…

15 telly

Here’s another simple way I’ve looked at the reg. vs. non-reg. debate.

Let’s take an income of $75k in Ontario for example.
marginal rate = 43.3% to 35% (assuming I max out my RRSP, taking me down 3 brackets)
cap. gains rate = 21.7%
CAN dividend rate = 20.3%

In retirement, I want an income of $35k and all of it will come from RRSPs (thus I use my average tax rate).
average tax rate = 16.1%

Without a spreadsheet, I know I’m better off with the RRSP. 🙂

16 Nobleea

Telly,

good point. It takes a while for some people to see that you might be in a higher tax bracket when you retire, but your RRSPs are taxed at your AVERAGE rate, which will be substantially lower. Meanwhile, your RRSP contributions get a refund at your marginal tax rate.

17 FourPillars

Telly – good advice.

MG – I have to agree with you that “double taxation” doesn’t seem to be the accurate terminology. From the spreadsheet however, the effect (whatever it should be called) has the same result as double taxation.

Mike

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