We’re almost at the halfway point of “RRSP season.” That’s the name traditionally given to the first sixty days of each calendar year where Canadians are encouraged to top up our RRSPs to allow us to claim the associated tax deduction on our 2017 tax return, which we will file this April.
But recently, Canadians have been asking some tough questions about whether the RRSP is still a good way to save for retirement. Let me address five of the top RRSP myths we hear on a regular basis.
Myth 1: There’s no point investing in an RRSP — you pay all the savings back in taxes when you retire anyway
While this is a fairly popular myth, it’s not accurate. Although you do pay tax on RRSP withdrawals, don’t forget that you also got a tax deduction upon contribution. If your tax rate is the same in the year of contribution that it is in the year of withdrawal, an RRSP effectively provides a completely tax-free rate of return on your net contribution. And, if your tax rate is lower in the year of withdrawal, you’ll get an even better after-tax rate of return on your RRSP investment. In fact, in many cases, even if your tax rate is higher in the year of withdrawal, you are still likely better off with an RRSP than non-registered investments due to the long-term compounding that is effectively tax-free.
Let’s take a simple example of Nigel who earns $80,000 annually and contributes $3,000 of his employment income to an RRSP. His marginal tax rate is 33.33 per cent today and he’s expected to be the same tax bracket when the RRSP funds are withdrawn. If his investment grows at 5 per cent, by the end of the first year it would be worth $3,150. If he were to then cash in his RRSP, he would net $2,100 ($3,150 less tax of 33.33 per cent).
Now suppose, instead, Nigel preferred not to go the RRSP route and invested his employment earnings in a non-registered account, with the same investment rate of return. This time, he would have to pay tax of $1,000 ($3,000 x 33.33 per cent) on his employment income before investing the net amount of $2,000 in a non-registered account. Growth of 5 per cent would increase the value of his investment by $100 ($2,000 x 5 per cent). If this was cashed in at the end of the year, Nigel would pay tax of $17 ($100 capital gain x 33.33 per cent x 50 per cent taxable capital gain), netting him only $2,083.
Myth 2: It’s better to invest in a TFSA than in an RRSP
Many Canadians believe that it is better to invest in a TFSA than in an RRSP, citing that TFSAs are better tax saving vehicles because they are completely tax-free.
If Nigel had invested his after-tax income of $2,000 in a TFSA, after one year at 5 per cent, the value of the TFSA would be $2,100 and this could be withdrawn from the TFSA without tax. Just like the RRSP example above, the end result is $100 of net income or growth. This is equivalent to a 5 per cent tax-free return on the net RRSP/TFSA $2,000 contribution.
The basic rule of thumb is that an RRSP is generally a better choice than a TFSA if you expect to have a lower tax rate in retirement. This is particularly likely if you are a baby boomer in your peak earning years and expect lower income when you are no longer working.
It is true that a TFSA may be a better choice than an RRSP in some cases, such as if you expect a higher tax rate upon withdrawal or will face clawback (repayment) of government benefits. Even so, you may not be able to save enough in a TFSA alone and may also need to supplement retirement savings with an RRSP.
Myth 3: It’s better to pay off debt
Paying off high-interest debt should definitely take priority over retirement savings, as it’s hard to get an after-tax, guaranteed annual rate of return of 19.99 per cent, a typical credit card rate today. The decision to pay down other debt, such as your low-interest mortgage, at the expense of retirement savings, is often an emotional one that isn’t driven by the numbers. With mortgage interest rates at near 60-year lows, albeit rising, neglecting your long-term savings in favour of debt repayment may result in sacrificing the quality of your retirement.
Myth 4: I don’t have enough money to save in an RRSP
You don’t have to make a huge investment in an RRSP. Making modest contributions on a regular basis can really add up. Suppose you were to invest just $100 each month in an RRSP from ages 30 to 65 and could obtain a long-term, average rate of return of 5 per cent on your investments. In 35 years, you would build up over $114,000 in your RRSP to use for your retirement. Your savings could provide over $9,100 of pre-tax income annually for 20 years to top up your retirement income.
It’s easy to set up an automatic savings plan to make regular contributions. Your employer may offer this option, with some employers even making matching contributions on their employees’ behalf.
Myth 5: If I save too much in an RRSP or RRIF, there will be a large tax bill when I die
The tax rules require the fair market value of your RRSP or RRIF as of the date of death to be included in income on your terminal tax return, with tax payable at your marginal tax rate for the year of death.
There are exceptions, however, which may allow a tax-deferred rollover to certain beneficiaries, such as a surviving spouse or partner or in some cases, a financially dependent child or grandchild.
Another strategy to minimize income taxes on your RRSP/RRIF at death is to take annual withdrawals from your plan during your lifetime to maximize the income that will be taxed at low rates by forcing additional withdrawals in years you are in a lower tax bracket.