This is why investing in an RRSP makes sense for many Canadians – Financial Post cafe madrid

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The March 1 deadline for the Registered Retirement Savings Plan (RRSP) is approaching, but some are questioning whether this age-old investment vehicle has the merit.

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Let me try to muddy the waters by suggesting that RRSPs are probably the best way for many Canadians to save for retirement. After all, with an RRSP, just like a tax-free savings account (TFSA), we can effectively earn tax-free investment income. And no, that’s not a typo: tax-free, not just tax-deferred.

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For decades, some readers have tried to convince me that RRSP investment income is simply tax deferred, since you must pay taxes on the funds when they are withdrawn from the RRSP, or eventually from its successor, the Registered Retirement Income Fund (RRIF). .

But if you go back to basics and really think about what happens with an RRSP contribution, you will quickly realize that the return on investment on your net RRSP contribution is mathematically equal to the tax-free return you could get from an TFSA. now, changes in tax rates. And, provided the time horizon is long enough, RRSPs can beat unrecorded investments even if your marginal tax rate is higher in the year of withdrawal than when you contributed.

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Let’s start with a simple example. Sarah has three choices when it comes to investing $1,000 of her income from work in 2023 for retirement: a TFSA, an RRSP, or an unregistered investment account. Her marginal tax rate for 2023 is 30 percent and she expects to generate a five percent annual return on her investments.

If Sarah wants to contribute $1,000 of her income to a TFSA, she must first pay taxes at her marginal rate of 30 percent on that income, leaving her $700 to contribute. At a five percent annual return, her TFSA will grow to $1,857 at the end of 20 years, and because it’s in a TFSA, the entire $1,857 can be withdrawn tax-free. Her after-tax return of five percent is, of course, the same as her pre-tax return, because the funds are withdrawn tax-free.

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Now let’s say Sarah chooses to invest that $1,000 by making a tax-deductible contribution to her RRSP. Because of the tax deduction, she can put the full $1,000 to work. Keep in mind that 30 percent (assuming her tax rate doesn’t change at retirement) of the money in her RRSP account actually belongs to the government through a tax deferral that applies to both her initial contribution and protected income and growth in the RRSP .

By applying the same five percent annual return for the next 20 years, with no annual tax, Sarah can build an RRSP of $2,653. But alas, not all RRSP funds are for her to spend. The piper must be paid. When Sarah takes the $2,653 out of her RRSP, and assuming her marginal tax rate is still 30 percent, she will pay $796 in taxes, taking her $1,857 after-tax out of her RRSP. This equates to a five percent annual after-tax return on her $700 net initial investment ($1,000 contribution minus $300 in tax deferrals on that initial investment).

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In other words, Sarah’s five percent after-tax return is exactly the same as her pre-tax return, meaning that she paid essentially no tax at all on the growth of her initial $700 net RRSP investment over 20 years. Thanks to the RRSP, she was able to save tax-free for retirement.

Now if Sarah invests that $1,000 in an unregistered investment account, she’ll have to pay taxes first, leaving her $700 to invest. If this $700 produces five percent annual income taxed at a rate of 30 percent, at the end of 20 years her unregistered account will be worth only $1,393 — significantly less than the $1,857 in her TFSA or RRSP.

These examples clearly show that both an RRSP and a TFSA will beat an unregistered account if your tax rate today is the same as the tax rate in the future. However, if your future tax rate is lower than it was in the year of deposit, using the RRSP gives you an additional advantage in that you can deduct your deposit at a high rate, but pay tax at a lower rate when you withdraw it. Conversely, if your tax rate is low now but is expected to be higher in the future, the TFSA will yield the better result.

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Some commentators have suggested that it could very well be a bad thing to accumulate too much money in an RRSP or its successor, an RRIF, because of the potentially high tax rate associated with withdrawals and the potential loss of government benefits such as old age pensions. Security.

To this I would say that even taxpayers who are in a relatively low tax bracket today should consider contributing additional savings to their RRSP once they have completely exhausted their TFSA contribution space. That’s because, depending on the return assumption, the number of years of tax-free compounding available, as well as the types of investment income you could otherwise earn by saving an equivalent amount in an unregistered account, the benefits of the tax-free preparation may outweigh the additional tax costs of a higher rate of withdrawal tax.

Jamie Golombek, CPA, CA, CFP, CLU, TEP, is General Manager Tax & Estate Planning at CIBC Private Wealth in Toronto. [email protected].

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