February 6, 2018 RRSP Tax and Math

There is widespread confusion about how RRSPs really work and whether they are a tax-avoidance mechanism or a mere tax deferral mechanism, or worse a “tax trap”.

The following illustrates divergent views on the matter:

A tale of Two Attitudes Towards Tax on RRSP Withdrawals

Imagine Frank and Joe have identical and relatively modest RRSPs and are both 65 and about to retire and start living, in part, on their RRSP savings.

Both contributed \$50,000 over a period of years starting at age 30 (So from say 1983 to 2017). Their marginal tax rates averaged 30%. Now, in 2018 the two RRSPs have grown to \$200,000.

They are both told that on withdrawals they will face a 33% marginal tax rate, a bit higher than when they contributed because both have modest defined benefit pension plans or other incomes such that the marginal tax rate went up.

Frank calculates that on his original \$50,000 contribution he got back a 30% refund so \$15,000. And he now realizes that he will have to pay 33% tax on \$200,000 for a total tax of \$66,000. He will net \$134,000 over a period of years as he withdraws. (We will ignore further growth in the RRSP).

Frank is wild: “This tax is outrageous! I never should have invested in an RRSP! I saved \$15,000 in tax and now will have to pay back taxes of \$66,000! Not only that but much of my gains were capital gains and dividends. I could have invested in a taxable account and paid WAY lower tax, like maybe 15 to 20%, not 33%! This RRSP has been nothing but a tax trap.”

Joe looks at it differently. He calculates that after the refund he only ever invested \$35,000 net of his own after-tax money. He looks at “his” RRSP as being \$35,000 funded by him and \$15,000 funded by the tax refunds. Or 70% funded by him, 30% by the refund. He notes that the RRSP quadrupled to \$200,000. He calculates that had his net \$35,000 quadrupled with zero tax it would net \$140,000. He notes that in the RRSP calculation he will net \$134,000 after the \$66,000 tax. He feels that the refund had funded 30% of the now \$200,000 RRSP. Ans so he figures the first \$60,000 of income tax is fully funded by the refund. He calculates that his net share of the tax will therefore be \$6000. He is paying \$6000 tax on his gains of \$105,000 (\$140,000 minus \$35,000) for a tax rate of 5.7% on the net growth in his net investment in the RRSP.

Joe is very happy with the situation. “I am SO glad I struggled and put that \$50,000 in the RRSP over the years he says. Not only was it savings that I otherwise would have spent, but the tax on the growth of my net \$35,000 cost of those contributions was only about 6% which beats anything I could have done in a taxable account all to heck. Even though my marginal tax rate went up, I came out way ahead. And just think if I could manage to get this money out at say a 25% marginal tax rate. That would mean the refund MORE than covered the tax on withdrawals, with money left over!”

So, two identical RRSPs both with 33% taxes on withdrawals, one taxpayer is screaming and regretful, the other smiling.

• Brian Acker

I think they both are correct. What I mean by that is it is all about your perspective. In a perfect world RRSPs make sense if you assume your marginal tax rate upon retirement will be lower than your tax rate through your earning years. For a lot of people this is a good assumption.

However, where the case is the opposite (marginal rate is higher on retirement) then you can certainly make an argument that it wasn’t the best investment vehicle especially today when you also have the option of investing in a TFSA rather than an RRSP. Having said that however, the power of being disciplined enough to invest in an RRSP on a regular basis and the refund you get, even in a higher marginal tax situation can be positive enough to warrant the investment.

My advice is don’t put all your eggs in one basket. First off pay down debt, secondly split your investing monies between RRSPs, TFSAs and taxable savings and pay yourself first and take a minimum of 10% of your gross and set it aside for long term savings and live on the rest. Sounds easy to do but is much more difficult in practice.

• Bill Mracek

You beat the tax man if the tax rate on RRSP withdrawals is lower than the marginal rate on the income used to make deposits. The tax man beats you when the rate is higher upon withdrawal. That said…the who point of the RRSP is to save for retirement, which is what both persons did. I’m lucky enough to contribute to both RRSP and TFSA accounts but if I had to choose one over the other I would choose TFSA because it’s more flexible, it removes the risk of tax rates being higher at retirement and it doesn’t interfere with other government benefits like OAS. One thing many people are not aware of with respect to OAS is that your monthly stipend is based on your previous year’s income. If you worked a full year and earned a substantial salary then you would have to wait a year before collecting OAS.

• Bill Mracek

I should have added that RRSP or RRIF income counts as income for the purpose of the OAS clawback, so it can penalize you in more than one way.

• Shawn Allen

Bill, what do you think of Joe’s perspective that with a 33% tax rate on withdrawal and 30% when contributed , he was still far better off than in a taxable account and the TFSA did not exist most of the years he invested and let’s set that aside and just compare RRSP to taxable account here. Did the tax man really beat Joe here?

• Bill Mracek

I’ve never seen the math comparing RRSP to non registered but I’m pretty confident that using an RRSP for investing would be the better choice. The registered account would generate an annual tax refund, which would be a huge advantage, particularly if it was reinvested. Putting the money in a non-registered account would expose dividends and capital gains to taxes, but those are generally treated more favourably for tax purposes than other income sources.

• Shawn Allen

I like the approach of Brian and Bill here to be respectful of both perspectives regarding whether Frank and Joe made the right choice in investing in RRSPs. Note that the TFSA did not exist for most of the years they saved which started in 1983 so that was not an option here for the most part.

• Brian’s last paragraph seems to be good advice. The hard part is finding the money to set aside for retirement. I think one part of the equation we are missing in this discussion is the RESP. I am trying to put enough away so that both my kids can pay for a bachelors degree free and clear and not start their adult lives in debt. This decision has made it harder for my wife and I to save for our own retirement (although I am a teacher and have a good, fully funded DB plan) but, in return, I will hopefully have peace of mind that my kids will get a good start to their adult lives.

• Shawn Allen

Agree with Cliff and Brian we should do more than just RRSP. But let’s focus on the RRSP example where Frank and Joe have the exact same result and tax and one thinks it ended up being a “tax trap” and the other thinks he paid only 6% tax on the gain on his net investment in the RRSP and is very happy.

• Shawn Allen

Perspective: Most people view the RRSP refund as free money that increases their net worth. If Frank thought it was free money and spend it frivolously, then he now finds he has a lot of tax to pay and regrets things. Understandable. But a better view is that the refund subsidies your RRSP and so if you get 30% refund, then the tax man is contributed 30% to the RRSP and if you end up paying 30% tax, then your 70% share grew completely tax free. Joe paid 33%, 3% extra over the 30% refund and it mathematically amounted to a 5.7% tax on his share of the RRSP growth. He views this as far better than in a taxable account. The TFSA was not available most of his savings life and let’s set that aside as he may have maxed that out separately in recent years.

• What is the result if you are clawed back your OAS. I.E. 51% tax rate when you withdraw?

• Shawn Allen

In that case, Joe’s net \$35,000 grew to \$200,000 but after 51% marginal tax he nets \$98,000. In the example we have the refund’s 30% “share” of the RRSP growing to \$60,000 and so covering the first \$60,000 of the tax bill. Joe’s net tax is then \$42,000. His \$35,000 had grown to \$140,000 for a pre-tax gain of \$105,000. He calculates his net tax on that as \$42,000 / \$105,000 or 40%.

A stiff tax rate and in this case a taxable account would likely have done better.

Joe is not happy but he figures \$98,000 for his retirement might still be better than if he simply spent the \$35,000 years ago.

But the point here was that Joe with a 33% marginal tax rate was still pleased with his RRSP. But had he contributed at 30% refund and taken out at 51% due to claw back, he might well regret it.

But the main point of the discussion here is was Frank right to view the RRSP as a tax trap when he faced a 33% marginal tax rate on withdrawal?

• All this discussion assumes that all of the RRSP contributions end up being gradually withdrawn. But reality is that much of these deposits are not withdrawned during our lifetime. The remaining RRSP and RIF funds are considered income for the year of passing and cosequently taxed at much higher rate. This is often ignored, but should be given consideration.

• Shawn Allen

That is certainly a good point. The top marginal tax rate in Ontario is 53.53% for dollars above \$220,000. If there is a spouse and both die while a big amount of the RRSP then there is quite a bit of tax to pay.

But I think people make the mistake of ever thinking that “their” RRSP was ever all theirs. It was pre-tax money and should generally be reduced by at least 30% to figure it’s value after tax.

• Shawn, is this understanding correct?

Since inside the RRSP all capital gain tax is delayed till the withdraw, if you do generate capital gain year in and year out, you’d be way better off to delay that tax in your investing years. In a way you’re using taxman’s money to compound your own money, sort of like Buffett using float to grow his own investment.

When you withdraw, the gain will be taxed at a level as income tax and not capital gain or dividend (lower rate). So really the debate should be the compound effect of delayed tax payment vs the higher marginal income tax rate. Conclusion, if one just uses RRSP as a saving vehicle it’s probably not worth it. One will need superior investing skills like Shawn to guarantee the hassle of RRSP is worthwhile.

• Shawn Allen

That sounds logical but the math is slightly different. It’s interesting to look at what happens when your marginal tax rate at the time of contribution (and tax refund) is exactly the same as at the time of withdrawal. In this case the math shows that the net cost of the RRSP after deducting the refund grows to exactly the same amount as the same net in a Tax Free Savings account.

That means that your net cost of the RRSP must have grown tax free since it matches the tax free savings account.

The best way to think of it is to consider the refund to be as if the tax man became a partner in your RRSP. With a 30% refund the tax man funded 30% of “your” RRSP. So later if the money doubles or triples or whatever and the taxman takes the same 30% then think of that as your “partner’s” fair share. Your 70% still grew completely tax free in that case.

Capital gains on your share of the RRSP are tax free when you think of it this way as is dividend and interest income.

It is indeed the years of tax free compounding of your net cost that is the benefit of the RRSP.

Things change when the marginal rate is higher at time of withdrawal. But even if your marginal tax rate is somewhat higher, it still beats a taxable account, but no longer ties a tax free account. At some point if your marginal tax rate at withdrawal is way higher than at contribution then the RRSP was not the best way to go.

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