By the time you read this the 2018 Registered Retirement Savings Plan (RRSP) deadline will have come and gone. However, I suspect most readers will have contribution room available, which can be found on your annual income tax “Notice of Assessment.” Many Canadians have tossed the RRSP into the trash bin, favouring the TFSA. I certainly agree with favouring the TFSA, especially for lower income Canadians, but wanted to make a case for also supporting the RRSP.
There are three key advantages of the RRSP over the TFSA. First, contributions are tax-deductible the year they are made, creating an immediate tax benefit. Contributions can be made the first two months of the current year and applied back to the previous year, which is why the deadline is usually February 28th or March 1st. Second, there are no dividend withholding taxes on U.S. stocks. Third, and a much less know benefit, is that retirement funds are generally secure from creditors in the case of bankruptcy. There are some caveats around this benefit which vary from province to province, so please check with your accountant. The main caveat is that if a large lump sum payment is made into an RRSP just prior to declaration of bankruptcy, it is unlikely to be protected for obvious reasons.
This third reason is why entrepreneurs should seriously consider an RRSP, especially starting out when finances of a business are less stable. Nobody starts a business with the intent of going broke but it frequently occurs.
Taking the money out
The key disadvantage of the RRSP is that when it’s collapsed, the money withdrawn is taxable. This is why so many have turned negative on the program even though most will be in a lower tax bracket upon retirement than when working. Farmers, who tend to pay themselves poorly while operating their farms but retire wealthy (please avoid throwing tomatoes at me for writing this) when they sell their operations, may be in a higher tax bracket upon retirement. Let me demonstrate, using the “Rule of 72,” how an RRSP could still be beneficial.
Let’s use a 40-year time period, with nine per cent annual returns, a 33.33 per cent marginal tax rate when the contribution is made, and a 50 per cent tax rate upon retirement. The money would double every eight years, leading to five doubles. A $1,000 contribution would compound to $32,000, and applying a 50 per cent tax rate upon withdrawal would leave $16,000 after tax. However, you also get a $333.33 tax refund. Investing this at the same rate of return would yield six per cent after tax, doubling every 12 years or 3.33 times in the 40 years. Therefore the $333.33 refund becomes $3,547, added to $16,000 becomes $19,547.
Simply investing $1,000 outside an RRSP, achieving nine per cent before tax or six percent after-tax would yield $10,640, considerably less than $19,547.
Dividend or capital gains investment income is generally taxed at a lower rate than straight income or interest income. If we used a marginal tax rate on investment income of half the 33.33 per cent for 40 years, the money outside an RRSP would become $18,720. The $1,000 inside an RRSP taxed at 50 per cent upon withdrawal, with a $333.33 tax refund invested outside the RRSP would total $22,240, still considerably more than investing entirely outside an RRSP. Please keep in mind this advantage exists despite the unlikely scenario of paying considerably more tax upon retirement than when working.
In conclusion the advantages of investing inside an RRSP are better with: a longer time horizon, higher rates of return, higher marginal tax rates, lower retirement marginal tax rates, and in the event of bankruptcy.
I hope this article equips you to use the “Rule of 72” to think through scenarios for your own specific circumstances.