Did you hear that Canada’s new plastic polymer bills contain a special agent that makes them smell like maple syrup? That’s a great story but that’s all it is; just a story. It’s another urban myth just like many myths surrounding RRSPs.
One myth we hear often is that RRSPs are a terrible idea because “you lose the lucrative dividend tax credit and the 50% capital gains reduction; that it is always better to invest outside of an RRSP.” It’s been proven time and time again that investing within an RRSP is more advantageous than investing in a non-registered account.
Let’s consider a simple example.
Assume an individual has saved $10,000 and she’s wondering whether she should invest it inside her RRSP or in a non-registered account. We’ll further assume her marginal tax rate is 40% and that she buys an investment that triples in value over a 20-year period.
Would she be better off investing inside or outside her RRSP?
To answer that question, we need to consider the tax refund. Assuming she has income tax deducted from her paycheque, a $10,000 contribution to her RRSP will generate a $4,000 tax refund because she’s in a 40% tax bracket. So, that $10,000 RRSP contribution wouldn’t actually cost her $10,000; it would cost her just $6,000 ($10,000 minus the $4,000 refund). Stated another way, at a 40% marginal tax rate, $10,000 inside an RRSP (which contains pre-tax dollars) is equivalent to $6,000 in a nonregistered account (which contains after-tax dollars). This is because if you are paid $10,000 and you are in a 40% marginal tax rate the government would take $4,000 leaving you with $6,000.
Now, let’s return to the example, using these numbers as our starting points. First, investing inside the RRSP: The $10,000 would triple to $30,000 after 20 years; that’s an average annual return of 5.65%. If she then sells the investment and withdraws the money, she’ll pay $12,000 of income tax (40 per cent of $30,000) and be left with a net $18,000.
Now, investing outside the RRSP: The $6,000 would grow to $18,000 after 20 years. If she then sells the investment, she’ll pay capital gains tax of 20 per cent (half of 40 per cent) on the $12,000 difference between her sale and purchase prices. After deducting $2,400 in tax, she’ll be left with just $15,600.
Verdict: The RRSP produces a superior return. Notice that the difference between the RRSP and non-registered totals ($18,000 versus $15,600) is equal to the capital gains tax ($2,400) that applies in the non-registered scenario. Far from “losing the 50% capital gains reduction,” the RRSP avoids capital gains tax entirely.
The RRSP will always come out ahead if you assume a constant marginal tax rate and if you start with amounts that are equivalent on an after-tax basis. That’s because capital gains, dividends and interest are not taxed in an RRSP, but they are taxed in a non-registered account. With an RRSP, the only tax is on withdrawals. People love to complain about the tax on withdrawals because it looks so large, but it’s really just the original tax they deferred plus the growth of that tax over time. As the example above showed, even after paying tax on withdrawals, the RRSP investor still wins. If an investor’s marginal tax rate is lower in retirement as it nearly always is, the benefit of RRSPs is even stronger.
What if someone’s marginal tax rate is higher in retirement? This would be extremely unusual as most people simply make less money when retired versus while working, But in this case wouldn’t that make RRSPs a bad choice? Not necessarily says Jamie Golombek, managing director of tax and estate planning with CIBC Wealth Advisory Services. In a research paper available at goo.gl/uaMJr9 he examined various scenarios. His analysis showed that, even assuming a fairly drastic 10%-percentage-point increase in the marginal effective tax rate, RRSPs would still enjoy an advantage over non-registered accounts given a long enough investing horizon. That’s because the benefits of tax-free compounding would eventually outweigh the impact of a higher METR on withdrawals.
So given the choice between an RRSP and a non-registered investment the RRSP is the superior choice.