Given that we are approaching the end of RRSP season, I thought it would be fun to dispel the most common RRSP myth that I see repeated over and over again in the media.

**Related –** 2012 RRSP contributions limit and deadline

Since the invention of the TFSA, there have been many articles written comparing RRSPs and TFSAs. One typical line of advice about RRSPs is that the RRSP is only advantageous if your marginal tax rate in retirement is lower than your marginal tax rate when contributing. If the marginal tax rate is the same in retirement as when you are making contributions, then there is no tax saved.

**Related: TFSA vs RRSP – Which is best for your retirement account?**

*Marginal tax rate is the tax rate charged on the last dollar earned in a year. *

This rule is simple, easy to understand, but it’s just not usually true.

*Note that this article really only applies to middle class earners. If you are in a low income tax bracket, then RRSPs are probably not beneficial and can even be harmful financially compared to alternatives. If you are going to be getting a very good pension in retirement, then RRSPs have little benefit as well. *

This rules seems to assume that taxes on withdrawals are paid at your marginal rate which is not the case.

When you make a contribution to an RRSP - the tax deferred from RRSP contributions is calculated at your marginal tax rate (or close to it, if your RRSP contributions span more than one tax bracket).

When you withdraw money from your RRSP or RRIF - the tax is calculated using your average tax rate (after other income sources such as pensions).

This is a bit complicated, so let’s look at this concept in chunks:

### RRSP contributions are made at marginal (or close to marginal) rates

If Sue from Ontario makes $100,000 per year and contributes $10,000 to an RRSP, she is able defer taxes of $4,314 (43.14% of $10,000) that would have been owed on her last $10,000 of income.

### RRSP or RRIF withdrawals are made at the average tax rate

When you earn income, there are different tax bracket rates that apply to different parts of your income. Taxtips.ca has all these tax brackets if you are interested. For example, Sue earns $100,000 per year and her marginal tax rate is 43%. But she doesn’t pay $43,000 of income tax each year. In fact, she will only pay about $30,000 in taxes for an average tax rate of 30%. This is because the tax rates for lower income levels is less than her 43% tax rate on her highest income.

### Example

Let’s look at a very simple example where Sue works for 10 years, contributes $10,000 per year to her RRSP (with no taxes being deducted at the source) and then decides to take a year long sabbatical and withdraws all the money from her RRSP in her sabbatical year. If her savings earns 3% per year, she will have $102,000 in her RRSP to use during her sabbatical.

The amount of tax she will pay on $102,000 of income (we’re going to pretend that there are no changes in tax rates in the 10 years) will be $27,647.

Has she saved any taxes? Yes – she would have paid $4,314 in taxes for each $10,000 that she saved over the ten years for a total tax bill of $43,140. In the end she will have saved $15,493 in taxes by using her RRSP as savings account even though the marginal tax rate on the withdrawal is the same as marginal tax rate when she made her contributions.

### Example 2

Ok, that example was pretty simple and leaves out an important fact for someone in retirement – they are very likely to have some sort of base pension income such as OAS and CPP and possibly other pensions as well.

Let’s look at another example which is still pretty simple, but includes some other base income.

Joe earns $82,000 per year in Ontario which puts him at the 39.4% marginal tax rate. He contributes $12,000 per year for 40 years and earns 5% per year. When he hits retirement he has $1,453,000 in his RRSP and decides to withdraw $58,000 per year. Joe is already getting $6,000 per year for OAS and $12,000 from CPP and $12,000 from a trust fund for a total of $88,000 per year. So he’s making more money in retirement and his marginal tax rate is a bit higher than when he was working (43% vs 39%).

The amount of tax he will be paying on the RRSP withdrawal portion of his income each year will be $17,891 which is an average tax rate of 31%.

Joe has significant pension income, makes more money in retirement, his marginal tax rate is higher, but the average tax rate on his rrsp withdrawal is still less then the tax rate he saved at when making his contributions.

### Summary

In both of these examples, the income in retirement (or sabbatical) is a bit higher than in the earning years. Even in this case, RRSPs will likely still save you some taxes or at worst – won’t save you any tax, but won’t cost you anything either.

Most people will earn significantly less in their retirement years and the tax differential will be much greater. A middle class earner who saves regularly and will make less money in retirement cannot lose by using RRSPs. They can even earn the same income in retirement or a bit more and still come out ahead with RRSPs.

{ 15 comments… read them below or add one }

This is an eye-opener article, Mike. Thank you for sharing this.

Norman,

Awesome post!

sorry, i don’t get this: (how did we get to that tax value?)

The amount of tax she will pay on $102,000 of income (we’re going to pretend that there are no changes in tax rates in the 10 years) will be $27,647.

@Dafster – I used the taxtips calculator for Ontario http://taxtips.ca/calculators/taxcalculator.htm and entered $102,000 as employment income which gives $27,647 as tax paid.

Now I realize I should have entered the amount under RRSP/RRIF withdrawals which results in taxes of $28,531. I’ll edit the article when I have time, but the numbers still support my point.

You’re right that the TFSA vs. RRSP decision is based on comparing the average tax rate saved on the contributions and the average tax rate on withdrawals; talking about marginal rates is just an approximation for small amounts. It’s interesting that you think of the marginal rate in retirement as the rate after considering the RRSP/RRIF income. I would have thought people would focus on the marginal rate before the extra income. So, I would have warned people that things aren’t as rosy as they seem if the average tax rate on withdrawals is higher than the starting marginal rate. In any case, I think we get to the same place in the end.

Thank you! This was very well explained and I am saving it to pass on.

It seems to me that withdrawals will be taxed at the taxpayer’s average rate ONLY if the taxpayer has NO other income. Assuming that the

withdrawal is taxed last, Part of of Joe’s 58,000 will be taxed at Joe’s

marginal tax rate, and the remainder at the next lowest rate(s).

If we pretend that Sue has no other income during her sabbatical year

the 102,000 will appear to be taxed at her average tax rate, but it

is still taxed at various rates and part of her income will be taxed

at her marginal rate . No ?

@leonard – Yes, that’s what my examples show. In Sue’s case, she has no other income and the withdrawal will be taxed at the average tax rate which of course is made up of the various tax rates inherent in earning $102,000.

In Joe’s example I calculated the average tax rate of the RRSP withdrawal only which includes his marginal rate, but doesn’t include the bottom tax brackets since they are used up by his pensions.

I note that you say this article really only applies to “middle class earners” and RRSPs can actually be detrimental to “low income earners” What is the range of income that you consider as “middle class earners” VS “low income”? and how are low income earners negatively affected.?

@Dianne – This article compares RRSP vs TFSA:

http://www.moneysmartsblog.com/tfsa-vs-rrsp-which-account-is-best-for-your-retirement-funds/

and it shows the different income levels.

Low income earners can be negatively affected because RRSP/RRIF withdrawals count against income-tested government programs such as GIS.

We wife has an RRSP and is in the lowest tax bracket. GIS is based on family income and I have a pension so there is still a tax benefit of a lower average tax. If she holds off on CPP until 65 she can withdraw about $11,000 per annum at zero tax, much better than the 22% paid at her marginal rate. Once CPP and OAS and bumps her income to $23,000 her average tax will still be lower.

These examples are great! And of course the benefits of earning income tax-free on the RRSP money for years just makes the situation better. Your two caveats are well placed though, although I suspect most people with a good work pension will have such a high PA that they wouldn’t be able to contribute much to an RRSP anyway.

Don’t forget that income from RRSPs is 100% taxable and that in some cases (middle income earners with pensions) will take it on the chin if they have too much RRSPs. Worth looking at non-registered baskets where investment taxable income is only 50% and where the tax can even be deferred for twenty years.

An RRSP is a tax deferred tool which you pay tax on the growth, while a TFSA, you completely avoid the tax on the growth altogether. In simple accounting terms, (legal) tax avoidance is generally better than tax deferral.

Therefore, an RRSP is only as good as what you did with the tax refund in the year of deposit. Did you use the refund to pay down your mortgage or reduce your debt – then you have maximized the opportunity. However, usually the refund is taken as a windfall and “blown” accordingly. When clients ask their advisors in February “should I pay down my mortgage or buy an RRSP”, smart financial advisors are trained to answer – “Yes, do both.” If you’re using your RRSP to reduce your debt then good on you, but otherwise max out your TFSA first.

The so called refund could more appropriately be called the tax deferred amount because it represents the tax money that you eventually must pay. So put that refund to work; don’t just throw it away on a vacation or a new car! Technically, one should keep track of RRSP refunds each year and then apply the eventual tax paid to see how the nominal tax balance is working on your tax deferral. Corporations do this in their financial statements.

Should we also consider the OAS clawback? My understanding is that when post retirement income is between about $72,000 and $118,000 every dollar above the threshold means 15 cents will be clawed back. How much would “Joe” lose to the clawback that he wouldn’t have lost if lower RRSP/ RRIF income kept him below the threshold?