RRSPs: Tax Trap or Ultimate Wealth Builder?
Depending on who you believe, RRSPs are either a “tax-trap” or “The Ultimate Wealth Builder”.
An RRSP contribution reduces your current income tax but the resulting investment, while it grows tax free, is taxable when withdrawn.
The tax savings from an RRSP contribution vary by province and vary greatly by income. For most Canadians with a taxable income between about $55,000 and about $100,000, the marginal income tax rate is about 30%. The following example using a typical 30% marginal tax rate illustrates the advantage of RRSP investing.
At a 30% marginal tax rate, a $5,000 RRSP contribution results in income tax savings of $1,500. Therefore, your net cost of the contribution is $3,500 but you have added $5,000 to your RRSP account. This results in the popular misconception that an RRSP contribution increases your net worth. That’s false because if you withdraw that $5,000 in the future and if your marginal tax rate remains 30% you will pay $1,500 in income tax and net $3,500.
That looks discouraging but there’s much more to the story.
If that $5,000 earns an average 7% return it will grow to $50,000 in 34 years. If you then withdrew the $50,000 at the same 30% marginal tax rate you would pay $15,000 in income tax and net $35,000 after tax.
Those who view an RRSP as a tax trap would argue that you saved $1,500 in taxes at the outset and are now paying $15,000 in tax and so it’s a very bad deal. They would say you would have been better off to invest the $5,000 in a taxable account where the lower tax rates on dividends and capital gains would result in a tax bill well under $15,000.
But that argument ignores the fact that the original investment only cost you $3,500 after tax. Therefore, a fair comparison would be to investing only $3,500 in a taxable account. And at 7% that would only grow to $35,000 before tax in the same 34 years. The RRSP netting $35,000 after tax easily beats the taxable account with $35,000 before tax, especially considering that income tax would have been payable every year on realized earnings in the taxable account.
The best way to think about this RRSP is that it was initially funded 70% by your own contribution and 30% by the income tax savings. It became a pre-tax pot of money. As it grows, think of it as being about 70% your money and 30% the “taxman’s” money. When it reached $50,000 it amounted to your 70% share having grown tax-free to $35,000. Think of the $15,000 tax as the taxman simply taking back “his” 30% share of “your” RRSP. He has not touched your 70% share even as it grew ten-fold.
But not all situations work out the same.
Some retirees will end up in, say, a 50% marginal income tax bracket. In that case the tax paid on the $50,000 withdrawal would be $25,000. Think of this as $15,000 representing the taxman’s 30% funded share of the RRSP plus an additional $10,000. Your net after-tax gain would be $25,000 minus $3,500 or $21,500. And that $10,000 tax would amount to a tax rate of 46.5%. In this scenario you would likely have been better off investing in a taxable account.
Most Canadians can expect to retire in a lower marginal income tax bracket and therefore the tax paid on RRSP withdrawals will represent less than the taxman’s percentage funded share of the RRSP. Believe it or not, this means that their own net cost of the RRSP has grown at a negative income tax rate. For example, if a contribution made at a 50% marginal tax rate can be withdrawn at a 35% marginal tax rate, the tax is less than the taxman’s funded portion of the original contribution.
The bottom line of this story is that the tax on RRSP withdrawals is usually not nearly as bad as it seems. If you had invested the lower after-tax dollars in a taxable account or even in a TFSA it never would have grown as large as the higher pre-tax amount has grown in the RRSP.
While an RRSP contribution can work out well as explained above, there are other investment choices that are even better for most Canadians.
In most cases, maximising TFSAs and (if applicable) RESPs and First Home Savings Accounts should take priority. RRSP contributions are now most applicable to those with higher incomes.
Unused RRSP room can also be very useful in the event of an unusually large taxable income in a particular year such as a large severance payment or a large taxable capital gain. And a spousal RRSP can be very beneficial for single income couples.
As indicated above, marginal income tax rates vary greatly by province and by income level. You can check the marginal income tax rate at your income level for your province at https://www.taxtips.ca/marginal-tax-rates-in-canada.htm
An RRSP contribution or withdrawal can also impact various income-tested benefits as well as the old age security clawback.
With the increased choices of tax-advantaged investment vehicles and the complexity of the income tax system, it’s becoming increasingly important to consult a tax accountant to help make your decisions.
END
Shawn Allen, CFA, CPA, MBA, P.Eng.
President, InvestorsFriend Inc.
Note: This article was originally published in the Internet Wealth Builder Newsletter dated February 19, 2024