Canadians – Do RSPs always make sense?

To start, I want to add that your comments will probably allow plenty of people (me included) to learn something.  After reading this entry, I’d love to hear your comments.  I might, after all, be completely out to lunch with this.  And if I am, I’d like to be set straight on this.

Here’s a scenario when RSPs might not make sense:  You and your partner are both government employees, expecting to make at least $30,000 a year (in today’s dollars) with your pensions when you retire.  Lucky devils.

Anyway, putting money in a RSP will give you roughly a 40% rebate today (on what you deposit) and then your money will grow capital gains free until you withdraw it.

But here’s the rub.  When you take it out, the money you remove will be taxed at your full marginal rate, and if you both have pensions putting you in the 40% marginal tax bracket, you’ll pay heavily on your withdrawals:  approximately 40 cents on every dollar.

I can understand that RSP money compounds capital gains free, but investors (in the above scenario) who choose to invest outside of a RSP in a basket of low cost index funds (with virtually no equity turnover) will compound most of that money free of capital gains– with the exception of the dividends and interest.

The investors, in the enviable above scenario (like a teacher married to a police officer, for example) wouldn’t have received a 40% tax rebate when depositing their money outside of a RSP account, but unlike the RSP investor, far less of their money would be taxed upon withdrawal.

Instead of every dollar withdrawn being liable for taxation, only half of the profits would be taxed.  For example, if $1000 is withdrawn from a $100,000 RSP, the couple with double pensions would be taxed at least 40% on that $1000 withdrawal.  They’d owe revenue Canada $400 in tax, so they’d “net” only $600 of that $1000.

In an equivalent non RSP account, with the investor taking $1000 out of a $100,000 account, they’d pay tax on half of the capital gain profit.

If the unrealized capital gains amounted to $50,000 of the $100,000 account, and if the investor took $1000 out of the account, then $500 of that would constitute a realized capital gain withdrawal,  and only half of that $500 would be taxable at the marginal rate.  So, while the RSP investor had to pay $400 tax on a $1000 withdrawal, the non RSP investor would only pay $100 tax on their withdrawal.

The non RSP capital gain would be $500, with $250 of it (50% of it) liable for taxation.  If the investor was in a 40% tax bracket upon their retirement (thanks to their pensions) then $100 in taxes would have to be paid on the $1000 withdrawal.  ($500 capital gain with 50% of it liable for taxes, leaves the $250 capital gain to be taxed at the 40% marginal bracket, giving a $100 tax liability)

The non RSP account only comes out ahead if the following scenarios play into effect:

  1. The investments are not in actively managed mutual funds.  These have a high taxable turnover, which would create an annual, taxable liability during profitable years which would sway the advantage towards the RSP account.
  2. Both partners would be in a high tax bracket because they’d each be eligible for government pensions (like teachers’ pensions, fire-fighters’ pensions, nurses’ pensions, police officers’ pensions etc).  The advantages of “spousal contributions” wouldn’t significantly benefit these couples unless their pensionable amounts were significantly different.

My theory stands that if even if a RSP account grew to three times the size of a non RSP account (thanks to the initial tax rebate and capital gains free compounding) then the lucky couple with the pensions would reap far less, after tax, from their RSP account than they would from their non RSP account—at the end of the day.

Now—there are many Canadians out there who are smarter than I am.  Please tell me.  Am I right, or is the logic flawed.

Please add a comment from the top of the page…





Andrew Hallam

I’m a financial columnist for Canada’s national paper, The Globe and Mail, as well as for AssetBuilder, a financial service firm based in Texas. I’m also the author of Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School (2nd Ed. Wiley 2017) and The Global Expatriate’s Guide To Investing: From Millionaire Teacher to Millionaire Expat (Wiley 2015). My mission is to educate, motivate and inspire people on basic retirement planning and best practices for investing, using evidence-based strategies. I’m happy to comment on your questions. However, please read the Terms of Use, Privacy Policy and the Comments Policy.

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11 Responses

  1. Hey Andrew! I don't think your logic is flawed, but RRSPs make sense for my wife and I, only from the perspective of contributing just enough to avoid paying additional income tax. We're lucky enough to be in higher tax brackets, and we use the RRSP as one tool in our financial toolkit. By chasing RRSP contribution room, I don't think we're doing ourselves any favours given many of your reasons above.

    Looking forward to more updates on Harry's account!

  2. Financial Cents,

    From what I've read from your site, you're pretty savvy. If you're in a higher tax bracket today than you will be when you retire (based on your future retirement income) then it totally makes sense.

    Thanks for the comment,

    Andrew

  3. The Rat says:

    I absolutely love this post!!!! I've been touching on this same theme in some of my own threads and it makes so much sense, in my view. Your logic is sound in a lot of ways.

    The way I see it, the couple you mention would be smart to grow a fairly large nest egg outside of a registered plan. With the pension they will be receiving come retirement, coupled with the fact that RRSP withdrawals will be treated as income, they will be facing a major dilemma if they have a $600,000 nest egg in registered savings and want to start living it up during retirement.

    It's inevitable – the tax man/woman will come. Whether it's once you start withdrawing your RRSPs or throughout the course of a taxable account's activity (with dividend income, distribution income, etc.)-you have to ante up at one point or another.

    I think one of the most overlooked aspects is what I call the 'sustainability factor'. What I mean by that (and BTW – I just termed it that off the cuff) is that when one retires and draws from their RRSPs, they are faced with the prospect of a diminishing principle. Because they are drawing from their whole nest egg, the principle becomes reduced and once those funds are gone, they are gone forever.

    In contrast, with a non-registered account, one can create a sizable enough cash flow stream so that the principal is preserved. For example, in my investment strategy, I have the vast majority of my investments in what I call cash flow generated vehicles, whether they are through GICs, blue chip dividend paying stocks, income trusts, etc. With this strategy, if properly managed, I can ensure the principal (or total market value of my investments) never goes down.

    As a result, when I have kids and I want to pass on my retirement dollars (i.e. the principal) to future generations, I can do so with less worry of losing out on funds that would otherwise evaporate faster by taking out RRSP dollars through withdrawals (I have a few years to get my head around estate planning as I don't have kids yet).

    I'm not sure how complicated it is to transfer RRSPs to a family member, but from what I can gather, in most cases it will get treated as income in similar fashion.

    But that's not to say that I don't think RRSPs are important. Now that I've left the workforce, I'm now using unused contribution room to offset the taxes I have to pay on dividends and interest income. I've calculated that I can repeat this process in the years to come, which is great.

    Just my thoughts. Love the thread.

  4. The Rat says:

    BTW – When I refer to the 'principal', I'm referring to the amount that enabled me to leave the workforce with a sufficient cash flow stream. I'm not trying to imply here that the total market value of my portfolio will never go down; essentially, all I'm saying is that I have things set up that the principal required for me to stay retired will never go down.

  5. Andrew Hallam says:

    Hey Rat,

    Thanks for the comments. I think you're really smart to look at the sustainability factor you described. Your dividends will increase over time with inflation, so if you're able to live on them today, without diminishing your principle, you'll likely be able to keep living off them. In fact, your dividends will likely increase faster than inflation.

    I'm not financially independent yet, but I hope to be in a few years. My wife and I want enough passive income to provide about $80K a year, indexed to inflation. I'm following William Bernstein's 4% rule–suggesting that 4% is the most I can take out of my account each year upon retirement, allowing the principle to grow faster than that (I hope) so that whatever is left in there is able to grow, thus allowing my 4% "payments" to myself to increase over time as well. The 4% benchmark Bernstein suggests is at the onset, and that withdrawal becomes the benchmark. For example, mine would be $80K per year. And each year I would give myself a 3% raise to cover inflation. If my account makes (averages) 7% or more per year (over the length of my retirement) then my principle should grow enough to cover my future "raises". But I'll need 2 million to create $80K a year, so I have to keep plugging.

    It sounds like you have a similar plan–but you beat me to it….and you're younger than me. You're rocking Rat!

    Andrew

  6. The Rat says:

    Hey Andrew,

    Thanks for the props; one thing's for sure, you've got a great plan in place and I'm learning a lot from your articles, insights and comments. I'm really glad to have 'met' both you and Financial Cents throughout my bloging endeavors.

    Out of curiosity, when you mention $80K per year for retirement, are you referring to that amount with tax implications taken into consideration? The reason I ask this is because you may in fact need less.

    When you retire, you no longer pay into government programs that you would normally pay into on a regular basis (such as EI, CPP, etc) while working. Coupled with the fact that you will be in a lower income tax bracket, the income you earn on investments and so forth will result in you having to pay less taxes. As a result, and as an example, a $30,000 annual income generated in investments is similar to retiring with say an annual income of $50,000 [I'm using rough figures here as I'm only trying to convey a point].

    I was just curious if you were aware of that, and if so, whether or your $80,000 is actually a lower figure that amounts to the full amount with tax considerations taken into account? Or is it the minimum amount you want to have given your preferred standard of living upon retiring?

    Cheers

  7. Great questions Rat,

    We're looking at a gross income of $80,000 as a retirement goal. When we repatriate, we'll put the retirement money into two separate accounts in Canada and we'll "snowbird" to Asia and South America during the winter months (staying away the maximum allowable time, while retaining residency benefits/medical etc).

    Our taxes will, unfortunately, increase exponentially when we repatriate our retirement money. We'll each earn about $40K in dividends and interest and pay Canadian taxes on that.

    Currently, as residents of Singapore, we pay 7% income tax a year. It's a pretty sweet deal.

  8. Thanks for the post!

    It's my theory as well. Not only that, I know from close family experience that if you have decent investments providing good returns, you may never touch your RRSP until you have to at 71. While I am far away from that day, the tax calculation is something I have done too. I look at it from two perspective:

    – Pure tax calculation including investment fees and possible capital loss usability

    – Theory of tax-free growth but without the ability to eliminate fees or losses

    One of my goal is real-estate investment that generate income and if all my money is in RRSP, it's painful to access due to the tax I'd have to pay. With the mortgage rules, it makes having access to fund even more important.

    That said, my employer has a matching contribution at minimum 50% with potential of 100%. It's hard to not leverage that. It does match up to 6% of your salary and that's the maximum I do. Unfortunately, the investment picks are slim and are managed through funds.

    I make it a priority to fill my TFSA first and I have to leverage my wife's now.

    Cheers!

  9. Andrew Hallam says:

    Hey Passive Income Earner,

    Thanks for the comment, and it's great to see that you've done some math on this as well–then figured out what was best for you.

    I went to your site as well, and loved your philosophy on viewing your portfolio as a future generator of cash, and then planning the portfolio size you'll need based on the cashflow you'll create for yourself.

    I tried to put a comment on your site, but I wasn't familiar with the settings. The comment I did write went into cyberspace somewhere, but not on your site.

    After I write in a comment on your site, what do I click below? If you can change it, that would be great. I haven't had troubles commenting on other blogs before.

    Cheers, and I look forward to reading more from you.

    Andrew

  10. Thanks Andrew.

    I am new to blogging and just took my leap of faith. I am using Blogger so it should be pretty standard to post and in fact I just noticed I had a wrong setting. I have rectified that now. Hopefully it will work now.

    I am looking forward to hearing more about your investing ideas and philosophy through your blog!

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