March 03, 2023Money Education Financial literacy Professionals
Life & Finance #6 - Registered Retirement Savings Plans (RRSPs)
RRSPs, in my opinion, are the most powerful saving vehicles available to individuals in Canada. Their unfairly negative reputation has resulted, primarily, from two actions. The first comes from the practice of treating an RRSP as though it is a savings account. Withdrawing funds from an RRSP while a person is employed means that a higher tax rate must be paid, compared to withdrawing RRSP funds while earning less income (in situations such as retirement). Secondly, when a person is withdrawing RRSP funds during retirement, it is easy to lose sight of the tax savings that were made many years before, when the RRSP contribution was made.
RRSPs are primarily designed for the individual that does not have a pension plan available through their place of employment. If a person has a pension plan, owning RRSP’s makes less sense, as their tax rate in retirement will be closer to what it was while they are employed. However, even in those circumstances, I advocate for the use of RRSP’s.
Let’s assume you earn $120,000/year. In Nova Scotia, your marginal tax bracket is 43.50%. Let’s say, every year you contribute $10,000 to your RRSP. Because of that contribution, you will on average, defer roughly $4,350 of income tax. The biggest benefit results when you carry on to invest that $4,350 tax savings. If you spend your tax saving instead of investing it, you will forgo the benefit of the tax deferral, and you will just have to pay the tax on the $10,000 when it’s withdrawn.
Following on with this example, let’s say you choose to save $10,000 in your RRSP each year. And you follow to make a $4,350 TFSA (tax-free savings account) contribution, using the $4,350 you saved in tax. 30 years later, assuming a reasonable 5% rate of return, you will have accumulated $665,000 in your RRSP and $265,000 in your TFSA. This totals $930,000.
Now, let’s look at your retirement years following these activities. Let’s say, the only other taxable income you have is your CPP(Canada Pension Plan) and OAS (Old Age Security), I’m going to assume that with inflation, the tax rates will remain the same in 30 years for the future dollars as they are today.
Let’s say, you begin drawing sustainably from your RRSP at $2,500/month, and you supplement this with withdrawals from your TFSA (not taxable income) as needed. You will be paying a difference of 15% tax on your RRSP withdrawal, because your tax bracket in retirement is materially lower. As well, you will have acquired a large sum of funds in your TFSA because you chose to invest the tax deferral.
If you run the same scenario, but instead of making the RRSP contribution, let’s say you saved the $10,000 annually in a TFSA. As it stands today, you will run out of contribution room. However, for the purpose of this example, we will assume you have contribution room.
After 30 years, you will have the $665,000 in your TFSA, a difference of $235,000 Tax free cash.
By following the RRSP investment route, you will not have all cash in hand, but if you withdraw it over your retirement years, you are going to pay consistently less tax on this money than when you withdraw it.