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.
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