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Instead of every dollar withdrawn being liable for taxation, only half of the profits would be taxed.  For example, if $1000 is withdrawn from a $100,000 RSP, the couple with double pensions would be taxed at least 40% on that $1000 withdrawal.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.