Is The RRSP Still Worthwhile?

by Mike Holman

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One of the big benefits of RRSPs is that when you withdraw the money, you don’t necessarily pay the marginal tax on the withdrawals but rather the average tax on the amount you withdraw.

For example if you withdraw $40k from your RRSP and you don’t have any other income source then you will pay only the tax payable on $40k which works out to a lot less than your marginal tax rate. If you have any income such as CPP and OAS – let’s say you get $12k per year from those, then the tax on the rrsp withdrawal will be the taxes payable on your income from $12k to $52k which will be more than the first example but still a lot less than your marginal rate.

What if you make a lot of money from your other income sources? In that case, the taxes due on the rrsp withdrawal might just end up being your marginal rate. If you are withdrawing your rrsp money and it’s all being taxed at or close to your marginal rate, is it still worth it?

You need to look at your own scenario and try to decide if it’s worth while or not.

Two main benefits of RRSPs:

1) The possibility of paying less tax on the withdrawal amount than the tax that was deferred on contribution.
2) No tax drag because of taxes on dividends, capital gains and interest.

Some common situations where RRSPs will probably have lesser value:

Defined benefit pension - if you work for the government or a company that has a good DB pension then the pension will probably put you into a moderately high tax bracket. If that is the case then you aren’t getting as much benefit from the RRSP since the tax you pay on the withdrawal might be the same or even higher¬†than the tax¬†you deferred when you contributed. You will still get some benefit from the fact that there is no tax drag in the rrsp. Another consideration is potential government clawbacks on your OAS (Canadian government benefit). This is one of those situations where you will probably be better off using the new TFSA account.

Low income - This is worth a post of it’s own but if you don’t make much money and can still save then the TFSA is a better choice than the RRSP.

Alternative income – If you have an alternative income planned for retirement such as dividend stocks (Derek Foster method or Smith Maneuver) and/or rental properties or any other income sources then they have to be considered as well. This is similar to a defined benefit pension in that if this money puts you at a reasonably high tax rate then any RRSP withdrawals will be taxed at a high rate and you lose part of the benefits of the RRSP.

More information on the TFSA

Benefits of the Canadian tax free savings account

Tax Free Savings Account (TFSA) Basic information for Canadians

Comparison between Canadian TFSA and American Roth IRA

Tax Free Savings Account refresher for Canada

ING offers TFSA refresher for Canadians

Is the RRSP still worthwhile because of TFSA accounts?

Using the Tax Free Savings Account (TFSA) for Canadians as an emergency fund

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{ 8 comments… read them below or add one }

1 Nobleea

“What if you make a lot of money from your other income sources? In that case, the taxes due on the rrsp withdrawal might just end up being your marginal rate.”

But, you are obligated to withdraw a certain amount of money from your RRIF every year. You are not obligated to work or have income from other sources. So are you really paying the marginal rate on your RRIF withdrawals? Why not flip it around and say you’re paying marginal rate on the other income sources?

2 Four Pillars

Nobleea – that’s something that I’ve seen debated quite a bit.

In my opinion, rrsp contributions are always optional – ie you make them because you want to make withdrawals in the future. You can control the timing and the amount of the contributions and withdrawals (except for the rrif minimum).

A defined pension benefit isn’t really optional in most cases and I would argue that neither is CPP or OAS, so the way I look at it (rightly or wrongly) is that you should look at the non-optional income sources as the base pay and everything else goes on top since you have more control over the latter.

The “extra” income would include income from rrsps, non-registered investments, real estate, business income, part time job income etc.

As an example if you look at a teacher in Ontario who has a very good pension plan. Assuming they are going to work long enough to qualify for a pension then they have to assume that they will get the pension as income, some CPP and some OAS (if it’s still there). For them to make the decision during their working years to contribute to rrsps implies to me that they are adding rrsps to their future income streams which in my mind makes it the “last” income which gets taxed at the marginal rate.

I’m sure there are lots of real life examples where it’s not as clear which is the “last income”.

The real issue is planning – there’s nothing wrong with working hard and saving a lot of money but sometimes you have to take a look at the end goal and make sure you are not screwing things up. As Preet said in his book – if you have “too” much money in your rrsp then STOP WORKING!

Mike

3 David

What happens if you decide to leave Canada upon retirement? Is it possible to withdraw funds from an RRSP at a lower tax rate as a non-resident?

Also, as a non-resident, would you lose access to CPP benefits?

4 Four Pillars

Hi David, as I understand it there is a flat percentage (25%?) of with holding tax in that case. Depending on the situation, that might work out better.

As for the cpp – I believe you can collect them if you are outside the country but if you move away then you might lose them.

Obviously if you are planning such a move then please consult a professional (or at least someone who actually knows what they are talking about).

5 Cheap Canuck

I look forward to your post (if one is forthcoming) about low income earners and the TFSA vs RRSP for retirement saving. This is something I’m still trying to get my head around and the more info I can soak up the better. People might not be happy we have to wait until 2009 to take advantage of the TFSA, but at least it gives us lots of time to figure out the pros and cons of each strategy :)

6 Four Pillars

CC – I am hoping to do a post or two on low income Canadians at some point. TFSA will certainly be part of that discussion.

Mike

7 Leon Dykler

Re: Four Pillars, CPP is not lost, regardless of country or location of residence.
(Always consult a professional).

8 Four Pillars

Thanks for the info Leon.

Mike

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