The ins and outs of RRSPs

Are they right for you?

RRSP, TFSA, FHSA, RESP, RDSP, RRIF – the list goes on and on. I’ve written before about various account types available to us as Canadians, but now it’s February and the RRSP deadline is right around the corner (February 29 this year), so I thought I might share the results of a bit of RRSP math with you. As a quick recap, Canadians may invest in a Registered Retirement Savings Plan (RRSP), which is subject to certain limits. Investing in an RRSP provides a tax deduction at your personal marginal (highest) rate. But when taken out, the amount withdrawn is added onto your income, increasing the tax owed. So, when does it make sense and when does it NOT make sense to use an RRSP?

I set out to answer that, and the answers may surprise you. First off, if the choice is between an RRSP and a Tax Free Savings Account (and you have sufficient TFSA room) then it’s fairly simple: if you will be in a lower tax bracket in retirement than you are at the time of deposit, then an RRSP is better. Otherwise, a TFSA is better (at least in this case). 

But what if you’ve maxed out your TFSA room? Now the choice is between an RRSP and a taxable account which makes the math much more complicated. There is real value in the tax-deferred compounding of income offered by an RRSP, so it no longer holds true that you must be in a lower tax bracket in retirement for the RRSP to work best.

There are so many variables, and each case is unique, but I ran some real-life common scenarios that I’ll share with you here. Let’s just start off by acknowledging a few assumptions that I made:

• I am of the opinion that we will ultimately get inflation back in check in the 2 – 3 percent range, so we’ll go with that here.

• With inflation in that range, I would expect Guaranteed Investment Certificates (GICs) and medium-term fixed income returns to earn about 3 percent.

• I would also assume equity rates of return to be around 7 percent. 

• In each case, I assumed that the contributor died at age 90 and that their estate was in the highest tax bracket. 

• I also made some real-world assumptions about the tax efficiency of the taxable portfolio vs. the RRSP. 

Be aware that these assumptions may not be applicable to you. In particular, they will definitely not be applicable to someone investing only in GICs as they only pay interest, which is taxed at a higher rate than a balanced mutual fund. 

With these assumptions in mind, here are a few of the real-world scenarios I ran and their results:

• A 25-year-old making $55,000 this year and investing relatively aggressively (earning 7 percent annually in an all-equity portfolio) is marginally better off with the RRSP, but it takes 70 years to get there. And that’s five years longer than my mortality assumption.

• The same 25-year-old, if investing in a balanced fund, should definitely not use the RRSP as it wouldn’t be better at any time in their lifetime.

• A 40-year-old earning $130,000 today should almost always use an RRSP, even if they invest very conservatively, and even though their tax rate at death will likely be 13 percent higher than their tax savings today.

• Even at age 60, someone earning $130,000 should probably favour the RRSP, but at that age it’s cutting it close.

In short, the younger you are, the greater your willingness to invest more aggressively, and the higher your income, the more likely you should favour RRSPs. On the other hand, being older, more conservative, and earning a lower income tend to tip the scale to the non-RRSP side. 

As indicated earlier, there are many unique factors that apply to each individual, so feel free to reach out and ask us to run a scenario for your unique situation. This is really not a case where you want to rely on rules of thumb. Talk to a professional and let them guide you through the process.

And don’t forget, the deadline to contribute to your RRSP this year is midnight on Thursday, February 29. Have a happy leap year!

Questions and comments can be directed to Arnold Machel at dr.rrsp@visionvest.ca.