Watch out for RRSP Urban Myths!
Having been an investment professional for the past 22 years, speaking with many hundreds of individual investors, there is one urban myth that has spread over that time horizon. Every so often an investor will tell me “RRSPs are no good, every time you take a dollar you get taxed on it, I’m better off with non-registered” or TFSAs, or some version of why RRSPs are not worthwhile. Let’s dispel that myth once and for all.
Where Did This Myth Come From?
Just last week, I had a conversation with an investor, a very smart gentleman who had been saving for years. However, he had not been making RRSP contributions every year. He earned a high income, had high RRSP limits not lowered by pension contributions, and at least $10,000 saved annually. When I asked him why he had not been buying RRSPs every year, his answer astounded me:
“Back in 2007 I was dealing with an advisor. He told me RRSPs are no good and that I should never touch them. I believed him and have never made an RRSP contribution since.”
As I could find no reason why this gentleman would not benefit tremendously from the tax-savings and shelter provided by RRSPs, I figured there may be many more misinformed people out there than originally thought, and this week’s article was born. Hopefully it can clear up any confusion and get some of you back on track!
The Registered Retirement Savings Plan (RRSP) was created by the Canadian Government in 1957 as a way to promote saving for retirement by individuals. Canada has a tax system that is graduated, meaning that, depending on how much you make, you pay a higher and higher percentage of income to taxes. For example, in 2015, you pay federal taxes of:
- 15% on the first $44,701 of taxable income
- 22% on the next $44,700 of taxable income
- 26% on the next $49,185 of taxable income
- 29% on every dollar of taxable income over $138,586
There are also provincial taxes to be added. Each province has its own calculations and brackets. For example, in Alberta, the system is the most simple. All income is taxed at 10%. Ontario has 5 separate brackets, ranging from 5.05% at the lowest to 13.16% on taxable income over $220,000.
You add federal and provincial rates together to get your combined rate. To keep things simple, let’s say you live in Alberta, and earn $150,000 of taxable income. Since you are taxed at 29% federally on every dollar over $138,586, and 10% provincially, your top marginal tax rate is 39%. In the 150K example, on the last $11,414 of taxable income earned, you have to pay a whopping 39%, or $4,451 of it, to the federal and provincial government.
To reduce things down and make it simple, let’s use a round number, of $10,000. In the above 150K example, 39% tax = $3,900. Instead of spending the remaining $6,100 after tax, say you placed the entire $10,000 into an RRSP, which essentially shelters the 10K from tax. You just saved yourself $3,900 in tax. True, you have to pay tax on any dollar you withdraw in the future, at your highest marginal rate. But you get the opportunity to delay paying that tax, for perhaps many decades, and do not have to start withdrawing until age 71.
So far the RRSP looks to be a great deal.
Comparison: RRSP, Non-Registered, and TFSA
Many investors I have spoken with, over the past 5 years, have told me they prefer the TFSA (Tax Free Savings Account to the RRSP. They like the fact that interest, dividends, or capital gains can be earned without ever having to pay tax on those gains. This is true, however we need to examine what happens to your money from the year that it is earned, all the way to how much is left over when you are ready to withdraw and spend. To do this, we will assume an equal comparison of a $10,000 contribution, into each of RRSP, Non-registered, and TFSA accounts. For consistency, we will assume all income earned is taxed at the same rate, 39%, both at time earned and withdrawn. We will also assume an investment that compounds once per year at 10% capital gains. The example of capital gains ensures the RRSP plan does not have an advantage over the non-registered account.
How do the numbers work over a time frame as little as 5 years?
- $10,000 contributed to RRSP
- Value after 5 years @10% = $16,105.10
- Net after 5 years if withdrawn @39% taxes = $9824.11
(remember there are no tax savings associated with non-registered purchases, so we do not have the full 10K to invest, only the $6,100 net of tax)
- $6,100 contributed to non-registered account
- Value after 5 years @10% = $9,824.11
- Capital gain = $3,724.11
- Taxes on 50% of capital gain ($1,862.06) if investment is sold after 5 years = $726.20
- Net after 5 years = $9,097.91
(no tax savings associated with TFSA contributions, instead of 10K there is only $6,100 to invest)
- $6,100 TFSA contribution
- Value after 5 years @10% = $9,824.11
- Taxes to withdraw = $0
- Net = $9,824.11
As can be seen in an apples to apples comparison, there is zero advantage to purchasing RRSPs over TFSA, and vice versa. Both are better tax-wise than non-registered accounts.
However, there are a couple of distinct advantages that an RRSP can have over the TFSA:
- Much higher contribution limit potential- In many cases, if income is high enough, you can contribute up to $24,270 (2014) to an RRSP. Current annual TFSA limit is only $5,500
- If your top marginal tax rate is lower when you withdraw, the better choice will be RRSP vs TFSA
Summary- Urban Myth Busted!
As we can clearly see, using cold hard numbers, maximizing RRSP contributions annually can provide your lifelong savings plan with permanent tax savings that compete with most other conventional Canadian contribution plans. Even if you are a few years away from retirement, you may not be withdrawing those funds for many years, so keep maxing contributions until you no longer can!
If you liked this article, be sure to share with others by using the social media buttons on your left, because sharing is caring!