RRSP DECISIONS AND CHOICES
This page discusses the various choices you have regarding RRSPs. It does not give you simple rules-of-thumb that supposedly apply to everyone in all circumstances. It does try to explain how to approach the issue, and how to make your own decision that is best for your circumstances.
In order to understand the discussion you must first have read and understood the previous page called the RRSP Nitty-Gritty. It is only when you understand where the RRSP's benefits come from, that you can make decision that maximize those benefits.
Asset Allocation Weightings
How you weight different asset classes to effect your desired asset allocation (AA), gets confused by the reality that the RRSP account includes the government's loan that will be paid back on withdrawal. Not all the account balance is yours. If all your savings are inside an RRSP then there is no problem. If you Asset Allocate each account you own independently then there is no problem. The problem is when you have assets in a taxable account or TFSA as well as a RRSP, and you Asset Allocate across the total portfolio.
Your goal is to determine the $$ allocations as a percentage of your wealth - with the government's loan within the RRSP removed. And then gross-up that $$ allocation in the RRSP to including the government's money.
Say your taxable account = $100,000 and your RRSP account = $300.000. Your expected tax rate on eventual RRSP draws is 33%. The RRSP account includes a third that belongs to the government. Subtract 33% from its $300,000 balance. Only $201,000 is your own wealth. Your total wealth to be AA is $301,000 ( $201,000 in the RRSP and $100,000 in the taxable account). Note that TFSAs are treated no differently than taxable accounts.
|(A) ||Account |
|RRSP||300,000||* (1 - 33% ) |
Say the Asset Allocation you want is 50% Debt and 50% Equity. Allocate your wealth, not the account totals.
|(B) ||Asset||Wealth |
Assume you have decided that Equity gets priority inside the RRSP.
* Fill the RRSP first with all the $150,500 Equity.
* There is still room (considering only your wealth) in the RRSP so fill the remaining $50,500 with Debt (201,100 - 150 500).
* The remaining $100,000 Debt goes into the Taxable Account.
* The RRSP assets are grossed up to include the government's loan. These are the amounts of the actual investments inside the RRSP.
|(C) ||Wealth||Account |
|Equity||150,500||/ (1 - 33% ) |
|Debt||50,500||/ (1 - 33% )|
|100,000|| 100,000||Taxable |
In practice it is unlikely that the retail investor would go through this math. A good-enough solution is to use the normal AA math and simply increase the target % allocations for assets that will end up in an RRSP. AA percentages are just a shot in the dark at the best, so nothing is gained by exactitude. Professionals could easily automate the math but they won't because they won't yet admit that part of the RRSP account is the government's money.
Which Asset Types Are Best Inside An RRSP ?
The term for this issue is 'Asset Location'. It is a play on words from 'Asset Allocation'. It is only relevant when you have multiple accounts (Taxable, TFSAs and RRSPs), and you Asset Allocate your wealth as a whole instead of each account independently. The question is "which asset type in which account will minimize tax?" You will hear a lot of contradictory advice. It is probably best to deal with the wrong advice first.
........... Wrong Advice ....................
• The traditional advice was to Keep interest-paying debt inside RRSPs because interest gets taxed at the highest rate. This may have been correct advice in the past when interest rates were much, much higher. For many decades returns from debt equaled, or exceeded, returns from equity. But that reality no longer exists. When returns are minuscule, any $tax on those returns is also minuscule, no matter how high the tax %rate. The objective is to save tax $ not tax %. Percentages won't pay the bills.
• It is common to hear "Don't put dividends and capital gains inside an RRSP because you lose the dividend tax credit and the capital gains exemption." You should already understand from the Nitty-Gritty page that the RRSP's benefit from profit sheltering reflects the net effective tax rate. This annualized rate incorporates all of statutory tax brackets, dividend tax credits, capital gains exemptions, delays in realizing capital gains, etc. it is only the NET tax that matters. What debits, credits or exemptions go into its calculation are beside the point.
• Another wrong statement often heard is ... "Put safe assets in an RRSP because investment losses cannot be written off", or "You lose the tax benefit of losses in an RRSP so don't put equities inside an RRSP." But profits and losses of individual years do not determine the net profits and net taxes that compound over time. People accept the possibility of losses from risky assets because they believe returns will be larger over time. So also will be their taxes. The only time you would lose by using an RRSP is in the very, very rare situation when losses exceed profits over the whole lifespan of the RRSP. Certainly at the start, when making the decision where to hold your assets, you never expect to lose money, or you would not invest in the first place.
• Another reason advisors give is ... "Put debt in RRSPs because profits in an RRSP are taxed at full rates on withdrawal. Since interest would be fully taxed in taxable accounts you lose nothing by this, and gain from the deferral of tax on the profits. In contrast the preferential tax rates for dividends and capital gains in a taxable account are replaced with a deferred, but full tax rate on withdrawal ... so you lose the benefit of the preferential rate". Hopefully you already know from the RRSP's Nitty-Gritty page that profits in an RRSP are never taxed, and that there are no benefits from deferral.
• One otherwise-well-respected pension expert claims .... Debt should be kept inside RRSPs because ... Interest rates are so low that, after paying taxes and deducting inflation, your real returns are negative unless the debt is held in a tax-shelter. The error of this logic is that inflation is irrelevant. Inflation impacts all your financial assets in exactly the same way, no matter what asset class is held, no matter whether income is interest, dividends or capital gains, no matter the rate of return earned, no matter whether the asset is held inside an RRSP or taxable account.
• Many people say to "prioritize assets with a large tax-efficiency-metric inside RRSPs and TFSAs". 'Tax Efficiency' (or the 'Tax Haircut") measures 'the difference between an asset's nominal rate of return and its after-tax rate of return' in a taxable account. This metric can also be thought of as 'the $tax paid as a percent of the $invested in year 1', or ...
( Rate of Return ) ... multiplied by ... ( Marginal Tax Rate )
This makes intuitive sense because your objective is to save as much $tax as possible. But the metric is wrong because it presumes that both factors are equally important. In fact the Rate of Return is more important over time. Faster growth makes a bigger account ... bigger accounts produce larger profits ... larger profits trigger larger $tax - regardless of the tax %rate. In the chart below Assets (A) and (B) would pay the same $1.60 tax in the first year. But Asset (A) with the larger rate of return creates more RRSP benefits over time. Even Asset (C) whose $0.75 taxes in the first year would be lower, quickly creates more benefits in an RRSP because of its higher rate of return. (This all assumes no change in tax rates between contribution and withdrawal and no rebalancing.)
• The question "Why is the academic advice wrong?" must be answered.
- None of the papers ever mention the effects of a difference in tax rates between contributions and withdrawal. Obviously when you leave out the second biggest factor determining the RRSP's net benefits, your conclusions will be wrong.
- The objective of many papers is to maximize a Utility function, not to maximize tax savings and wealth. Utility functions are all about risk, not maximizing your ending wealth.
- The risk adjustments made do not reflect most people's decision process. They assume that a (e.g.) 20% loss in an RRSP is considered worse than a 20% loss in a taxable account. They presume your emotional response will differ because you tell yourself "Oh, I only really lost 12% (in the taxable account) because my tax rate on profits is 40%. So I can accept more risky assets in my taxable account, than in my RRSP." In real life people never react that way.
- Some papers specify that their model has a one year time span. For others it is unacknowledged. As shown above - compounding over time changes the benefit realized from different assets.
- In their discussions many indicate they have the errors in understanding 'how the RRSP works' that are proven wrong on the Nitty Gritty page. They say things like "profits are taxed on withdrawal at full tax rates".
- All papers presume some tax structure for certain assets types. Their conclusions would not hold in countries with different taxes, or after politicians change the tax rates. Their conclusions apply only to those in the tax bracket assumed, (usually the top tax bracket) not to everyone else.
- Many make invalid assumptions like 'capital gains are never taxed', not because the tax rate is zero, but because they assume investors never sell, not even in old age.
- They never come to variable conclusions based on variable rates of return. They always presume the rate of return for each asset class is a 'given'. That makes their conclusion worthless when (eg) interest rates are far lower than their historical average.
- Older papers that model the choice of companies to either a) contribute to their staff's pension plan, or b) pay down debt, or c) invest for growth ... from the point of view of the investor holding that company's stock .... are still referenced as accepted wisdom regarding the Asset Location preferences of the beneficiaries of pension plans. Yet the model is completely different. The POV is completely different.
........... Correct Understanding ....................
As a general rule Put high return assets in RRSPs and TFSAs unless .....
(a) the effective tax rate on their profits would be very, very low. E.g. Canadian dividends are taxed at 0% for people in the bottom tax bracket.
(b) the time-span considered is very short. This implies that the AL choice should change as withdrawals become immanent. The tax-efficiency metric discussed above would then become relevant.
(c) you expect RRSP savings to be taxed on withdrawal at a higher rate than you were for the contribution. The $penalty created by the higher tax rate is larger when the account is larger, so low growth assets become the better choice. Savings in a TFSA don't have this problem.
You can see how important the Rate of Return is with the map below. Benefits are calculated for each intersection. The gradient lines show equal benefits, increasing from the bottom left to the top right. The highlighted points represent different possible assets - for example, debt paying 4.75% taxed at 22%, and equity with 6.25% capital gains taxed at 11%. Both assets show the same RRSP Benefit. Since Debt is now paying much less than 4.75% you should conclude that equity is better inside the RRSP.
This gradient takes shape at 20 years. Over shorter time frames the gradients rise more sharply on the left, showing that the tax rate has more influence. The gradients also rise more sharply on the left when the withdrawal tax rate is higher than the contribution's tax rate. The calculation of benefits for the map above come from the "Asset Location" tab of the Deconstruct Benefits spreadsheet.
.............. Rebalancing AA Between the Accounts .................
If you re-balance between asset classes regularly the Asset Location decision makes much less difference. Use the tab called "Year by Year" in the Deconstruct Benefits spreadsheet. Here the two assets are modeled to rebalance each year. Choose any combination of Rates of Returns and Tax Rates. The ending wealth will usually be higher when the asset with the larger Rate of Return is inside the RRSP. But the difference in ending wealth after 30 years will rarely be greater than 5% or 10%. Hardly worth all the effort.
For example, input the variables for Assets A, B and C in the diagram above. Play with the Year-by-Year tab's model to see that yearly rebalancing also increases the period of time necessary for the benefits created by Asset C (in the diagram above) to cross over and exceed the benefits from Assets A and B.
........... Choice Between RRSP, Taxable Account and TFSA ....................
As long as there is no anticipated change in tax rates between contribution and withdrawal, the benefits from an RRSP and TFSA are equal. First you decide which assets will have the smallest benefits (use the top tab of the Deconstruct Benefits spreadsheet) - and make them lowest priority for room in the tax shelters. Then it makes no difference which tax shelter you use for the rest ... with two exceptions
• 15% withholding tax is deducted by foreign countries from distributions crossing their borders. You lose this when the asset is in a TFSA. So it is preferable to hold foreign assets in an RRSP rather than a TFSA. You can also sometimes lose the 15% in an RRSP, depending on the asset's structure. This is discusses further in a separate section below.
• If you are so wealthy that you do not expect to spend all your savings before you die, then putting your highest growth assets in a TFSA protects more wealth from the minimum required withdrawals of the RRSP. Mostly these rich people would not realize a Bonus from RRSP withdrawals at lower tax rates, so there is no conflicting choice.
A difference in tax rates between contribution and withdrawal creates a Bonus or Penalty inside the RRSP. Your objective is to maximize any bonus and minimize any penalty. So prioritize in an TFSA the asset that would create the largest RRSP penalty, or the smallest bonus. See an example how this is done for the most complicated of situations (which few people will face) - three assets with widely different returns, three accounts, and a higher tax rate on RRSP withdrawals. Use the top tab of the Deconstruct Benefits spreadsheet to fill in the three columns below for each asset. .
|Term||30 years |
|Tax on Cont'n||30% |
|Tax on Wthdr'l||45% |
|Change in |
|A ||8%||15% ||9,934 ||40,122||(30,188) |
|B||5%||20%||2,134 ||15,100||(12,966) |
|C||3%||40%||2,791 ||10,073||(7,282) |
Rank each column with largest benefits at the top.
|1 ||2||3 |
|Change in |
|A ||A||C |
|C ||B||B |
|B ||C||A |
Fill the taxable account first with the lowest ranked assets in columns 1 and 2 - the assets with the smallest benefits in either RRSPs or TFSAs. Here there is
disagreement between Asset B and C, depending on which account the asset would end up in if not
chosen for the taxable account. Looking at column 3 you see that Asset C is least likely to end up in the TFSA because its penalty from the higher tax rates is smallest. That makes Asset B the last to fill any tax shelter and first into any Taxable account. Asset C comes second.
Fill the TFSA next with the lowest ranked asset in the column 3 (Asset A) so that the assets with the smallest Penalty go into the RRSP. That is Asset A first, then any left-over with Asset B. That leaves Asset C with the smallest penalty from the higher withdrawal tax rate to fill the RRSP.
Withdraw Funds Early?
Many people wrongly presume that the RRSP's only benefit comes from contributing at a high tax rate and withdrawing at a lower rate. They decide, when higher withdrawal rates are immanent, to stop contributing and to melt-down existing assets preemptively at lower tax rates. This issue is the same one faced by those people retiring early and deciding which to draw down first, their RRSP or Taxable account.
It is often wrong to withdraw cash early. The benefit from withdrawing at a lower tax rate will be offset by the loss of the RRSP's main benefit - the protection of profits from tax. There is a trade-off. The longer the cash stays within the RRSP the more profits get shelter. The greater the tax rate you would face on investment income in a Taxable account, the greater the RRSP's tax shelter benefit. Try your own variables in the Withdraw RRSP or Taxable First spreadsheet.
There are some situations where an early withdrawal makes sense.
a) If you have some other way to shelter profits from tax, then the decision is correctly made according to the marginal tax rates. For example, if you have unused contribution room (and unneeded in the future) in a TFSA, or if you will use the withdrawal to purchase a Personal Residence.
b) If you face a year of abnormally low taxable income, you can 'use up' the lower tax brackets by withdrawing RRSP money to create taxable income, then re-contribute the same dollars the next year at a higher tax bracket. This will destroy contribution room but does that matter? E.g. For low income people whose retirement funding will come mainly from CPP, OAS and GIS, the TFSA room alone will be more than adequate for savings. E.g. For people buying $1M homes it is unlikely they can both repay the mortgage plus accumulate enough to use up all TFSA and RRSP contribution room. The destruction of contribution room may not matter.
c) If your tax bracket is temporarily high this year you can reduce your taxes by contributing to an RRSP, and withdrawing the $$ next year at your normal (lower) tax rate. This is the same strategy as (b) above but in reverse.
d) It is correct to prematurely draw down an RRSP in the years that trigger the lowest withdrawal tax when later profits earned in a Taxable account will not create $tax. E.g. In the bottom tax bracket dividends are taxed at 0%. A lot of people use this argument, but don't forget that in retirement CPP and OAS which will likely use up all the Personal Exemption tax credit, making your investment profits taxed. Make sure you will not inherit a million dollars from Aunt Martha, or sell the family home (putting the proceeds into now-taxed investments).
e) If you have both low income and small savings at retirement, then collapsing the RRSP early may be preferable when future RRSP draws would trigger claw-back of GIS benefits.
Delay Claiming The Tax Deduction?
The RRSP administrative rules do not force you to claim the tax deduction in the same year you contribute. Since the contribution credit is calculated at your top marginal rate, when you predict your marginal rate will rise in a few years it seems intuitively better to delay the claim. After all, a $440 refund (44% tax credit on $1,000 contribution) is better than a $340 refund (at 34%). See list of 20 weblinks all recommending a delay. The problem everyone ignores is that any delay in claiming the tax deduction creates a growing penalty equal to the missing profits not earned by the Contribution Credit in the interval. This penalty from a delay was explained on the previous Nitty Gritty page.
First make sure that you will move up a tax bracket in the future. That is not the same as being paid more. Tax brackets grow with inflation, so it is only pay raises greater than inflation that will move you up. You must end up with sufficient income taxed at that higher rate to use up both the then-current savings plus the backlog from any delay. If only the last $10k of your wages are taxed at the higher rate, and you expect to continue adding savings at $9k per year, then it will take 20 years to draw down a $20k backlog, $1k per year.
When you are sure your marginal tax rate will rise in the future, it is always best to use a TFSA in the interval. The TFSA gives you the same income-shelter as the RRSP without any effects from changing tax rates. But maybe you have no extra TFSA contribution room. Then your choices are ...
- You may stash the savings temporarily in a Taxable account until your income puts you into that higher tax bracket. This comes at the cost of losing the benefit from sheltering profits from tax.
- You may use the RRSP normally, claiming the tax deduction now. This comes at the cost of paying the penalty from a rise in tax rates.
- You may use the RRSP but delay claiming the tax deduction until you are in that higher tax bracket. This comes at the cost paying the penalty from that delay.
The Delay Deduction?spreadsheet models your choices and allows you to input your own variable assumptions. The common starting point for a comparison of the choices must be your after-tax savings, e.g. $1,000 that can be invested to earn 8%. The chart below shows the resulting wealth for each choice,when your tax rate starts in one tax brackets and ends up in the next higher. It assumes your tax rate changes at the end of each interval.
There are some general conclusions when using a TFSA is not an option.
- An RRSP with a delayed-deduction is NEVER the best choice.
- A Taxable account is best when the interval will be short. Especially at low tax rates, the taxes paid on profits will be small relative to the Penalty from an increase in tax rates or the Penalty from a delay in claiming the tax deduction.
- An RRSP with immediate-deduction is best when the interval will be longer, (but never when your tax rate now is 0%).
This is because the cost of paying taxes grows faster with time, than the penalty from a higher tax rate at the end.
- It is quite reasonable to use an RRSP with an immediate tax deduction when your future is not certain. Since the future is unknown, unless you know for a certainty that your tax brackets will be higher later in life, it seems a poor trade-off to continually pay taxes on profits using a Taxable account just to avoid the Penalty from an increase in tax rates that may in fact never happen.
- The RRSP delayed-deduction choice is NEVER the best choice. It is sometimes better than using the RRSP normally, but in all those situations using the Taxable account gives better outcomes than either. This may be your choice when forced to use an employer's RRSP plan to get their matching, or when you have already made the RRSP contributions and are left with only the choice to claim the deduction or not.
- The RRSP delayed-deduction choice is only better than using the RRSP normally when the interval is short.
The Penalty from a delayed deduction grows faster than the Penalty from an increased in tax rates.
The maximum delay can be roughly calculated by ...'the percent increase in the tax rate divided by the investment's rate of return'.
E.g. ( 39% / 33% ) - 1 divided by 8% = 18.2% / 8% = 2.3 years maximum delay (when moving from 33% to 39% and earning an 8% return).
Disclaimer - This analysis presumes that at the later date when your tax rate is higher, all your options are still open. There is a strategy to contribute to an RRSP before age 71, and defer the tax deduction for later use reducing clawbacks of other pension benefits. The presumption would not hold in that situation because you cannot make contributions after age 71.
So, this analysis presumes that there is RRSP contribution room for each alternative. For the vast majority of people this will be true. But some good savers use up all their RRSP and TFSA contribution room each year, and expect to continue doing so. Their contributions are constrained. The three RRSP choices above use up different amounts of contribution room. The longer the delay before contributing, and the higher the tax rate, the more room is required. For these good savers, contributing immediately on January 1 to fill all RRSP and TFSA contribution room is optimal. The decision on when to claim the RRSP deduction is the basic time-value-of-money trade off between $$ received now vs. larger $$ received later.
The rules give you some leeway for over-estimating your contribution room. They allow a one-time $2,000 over-contribution without penalty. One option is to withdraw the funds, but then the $2,000 becomes taxable for a second time, once when earned and again when withdrawn. The far better option is to wait until the contribution room has been earned, and then claim the tax deduction.
Many advisors tell you to purposefully over-contribute so that this $2,000 can grow with tax-free compounding. They imply that the longer this $2,000 is not deducted, while other contributions are, the better. In essence this situation is no different from that discussed immediately above - the choice to delay claiming allowed deductions. The advice is usually wrong. It needlessly creates a Penalty from Delay that is greater than the Benefit from Profit Sheltering.
|Account ||Taxable ||RRSP |
|After-tax savings at top tax bracket ||$2,000 ||$2,000 |
|Grows at 8% in 3rd tax bracket |
with 50:50 div:capital gains
|Future Value at 20 years ||$6,802 ||$9,322 |
|RRSP withdraw at 39% || ||<$3,636> |
|Claim Contribution Credit at last || ||$780 |
|Wealth at end ||$6,802 ||$6,466 |
The advice IS always correct IF your investments earn profits that are taxed at full rates. It is correct no matter what rate of return is earned and no matter how long the delay in claiming the deduction. This is because the government pays part of the Penalty from Delay according to its % funding of the account.
But few people's portfolios earn 100% interest. Most earn Canadian dividends and capital gains that are taxed at preferential rates, and so the profit-sheltering of the RRSP is a smaller benefit. The lower the effective tax rate on investment profits, the less likely an over-contribution will be beneficial. Also, the lower the rate of return earned, the less likely. Also, the shorter the delay in claiming the over-contribution, the less likely. The box below shows the minimum rates of return earned by investments necessary before there is a benefit from over-contributing the $2,000.
|Tax bracket |
Statutory tax rate
|Profits 1/3 interest, 1/3 Canadian dividends, 1/3 capital gains|
|20 yr delay ||10.7%||7.5%||6.3%||5.9%||5.7%|
|5 yr delay ||69%||91%||35%||32%||31%|
|Profits 1/2 Canadian dividends, 1/2 capital gains |
|20 yr delay ||29%||15%||11%||10%||10%|
|5 yr delay ||never||107%||69%||61%||55%|
Paydown Debt Or Contribute To An RRSP?
It can be argued that having debt hanging over your head may prompt you to save more than you would if the cash were to go towards retirement savings. The debt may also help to change poor spending behavior that gave rise to the debt in the first place. It is more commonly argued that leveraged investing should be avoided almost always. You need to know yourself. When the employer will match RRSP contributions it should be obvious that the RRSP choice is better.
The following is purely math. In the choice between using savings to repay debt vs invest in an RRSP depends on (i) the difference between the after-tax returns of the choices, and (ii) changes in your future tax rates making delayed RRSP contributions more/less optimal. You must compare the cost of debt to the low-return safe assets you would own, and not ignore differences in risk. You must estimate the cost of debt over the full period if interest rates are expected to change.
First decide if the debt's interest is tax-deductible or not. If it is tax deductible then calculate its after-tax cost by multiplying the interest rate by (1 minus your marginal tax rate). For example if the stated interest rate is 5% and your marginal tax rate is 40% then the after-tax cost is 5% * (1 - 0.4) = 3% after tax.
Then determine the rate of return you would earn with an investment inside an RRSP. Do not fudge the conclusion by assuming you will earn a high return with a risky asset. Paying down the debt is a guaranteed return. So keep the risk comparable. Choose an investment of equally low risk, not the portfolio's average. It is likely that its rate of return will be lower than the interest rate of the debt. Most people's portfolio includes a mix of debt and equity. Use the return expected on the safest debt you own. Since profits are tax-free inside an RRSP there is no need to adjust the expected return for taxes.
Then consider the effects of the eventual debt repayment when you originally invested in the RRSP instead. Pretend that at the debt's maturity you suddenly have (in both choices) additional savings equal to the compounded value of the unpaid debt. If you originally chose to contribute to the RRSP you must use this new savings to repay the debt. If you originally chose to repay the debt, you can now contribute this new savings to the RRSP at tax rates that will likely have changed. Compare the ending balances in the RRSP to see the effect of the change in tax rates. Higher tax rates in the future make debt repayment now the better option, and vice versa.
An example is tracked below. A 3% rate of return is assumed for both the investments and the debt. If there were no change in tax rates the two options would have equal outcomes. Here, there is a $7,500 debt. The tax rate is 25% now but expected to be 35% at the end of the debt's term. With $10,000 of before-tax-wages your choices are
(A) Pay off the $7,500 debt with what remains after paying your employment income taxes. You are left with no assets and no debt. Model the future size of the debt as if it were NOT paid off = $11,685. Additional savings would be grossed up to make an $17,977 RRSP contribution (11,685 / (1 - 35%)).
(B) Keep the debt and put the cash into an RRSP where it would be invested in safe assets earning an exactly equal 3% return. After 15 years the account would equal $15,580. Additional savings = $11,685 would be used to repay the still outstanding debt.
| ||Debt ||RRSP |
|Wages ||10,000 ||10,000 |
|Employment Tax at 25% ||(2,500) || -   |
|Invest or Reduce Debt ||7,500 ||10,000 |
|Grows over 15 years||at 3%||at 3% |
|Future Value ||11,685 ||15.580 |
|Additional Savings ||11,685 ||11,685 |
|Repayment of debt|| ||(11,685) |
|RRSP contribution at 35% ||17,977 || |
|Ending RRSP account ||17,977 ||15,580 |
The banks want to lend you money, especially against such safe collateral as a government refund. Every year in RRSP season the media asks the question "What should I do with my extra cash - pay down the mortgage on my principal residence, or put it into an RRSP?"
The answer always given is "Put it into an RRSP and use the contribution tax credit to pay down the mortgage". This is a beautiful answer. It is short, easy to say, easy to remember. It does not require any knowledge about the questioner. It is supported by the fallacy that the contribution tax credit is a 'benefit'. It seems to satisfy everyone no matter what the interest rate of their mortgage, no matter what the return on possible RRSP investments. And it is wrong.
It is exactly that universality that should raise red warning flags. Financial decisions are rarely universal,and never 'regardless of rates of return'. Now that you understand the RRSP system you should know where the error-in-logic of this advice is. It is based on the false claim that the contribution tax credit is a 'benefit'. Hopefully you already know that the tax credit is only the illusion of a benefit.
Many articles pushing you to keep debt while contributing to an RRSP base their reasoning, not on anything specific about RRSPs, but on the general question "Should you invest with leverage?" The math for leverage is discussed on the Leverage page. The promise is that your investment returns will be larger than the cost of your debt. But life is not always so kind. And when your cash is behind the tax-wall of an RRSP it is a lot trickier to get it out when you really do need to get rid of the debt.
Another commonly heard reason for contributing to an RRSP even while you own 'good' debt is ... Investments in the market become less risky when your investing time frame is longer. Contributing early to a RRSP, instead of paying down mortgage debt gives those investments a longer time frame. The counter argument is shown in the graph on the Saving Money page . Extending the investing horizon by 10 years did not moderate ending results.
TFSA or RRSP ?
With few exceptions, people should try to maximize their allowed contributions to both RRSPs and Tax Free Savings Accounts (TFSAs). In real life most people cannot save that much and must choose. There are 14 issues to consider.
- $1,000 saved ≠ $1,000 saved - The choice is never between adding $1,000 to an RRSP or adding $1,000 to a TFSA. If you can save $1,000 in a TFSA then you can save (at a 33% tax bracket) $1,500 in an RRSP. The $500 tax reduction from the RRSP contribution should end up in your savings account somehow. Either less tax is deducted from your paycheques, or your taxes paid on filing your tax return is smaller, or you get a tax refund. That $500 allows you to save more in an RRSP. Both accounts would then shelter the same after-tax saving. You need the larger RRSP to pay the eventual withdrawal tax.
- Qualify To Contribute? - Contributions are limited for both accounts. Contribution room starts accruing for TFSAs at age 18 and continues till you die. For RRSPs you must have Earned Income that was reported on a tax return. Children may find account providers won't open an RRSP for them when they are minors. RRSP contributions stop after the year you turn 71 and the plan evolves into a RRIF. If one's spouse is younger than 71 you can still make RRSP contributions to the Spousal RRSP.
- Carrots and Sticks - The RRSP's tax reduction on contribution and tax on withdrawals are powerful emotional carrots and sticks to encourage saving and prevent the raiding of those savings before retirement. Judging from the statistics of large numbers of early withdrawals, the 'stick' part does not work so well. In contrast, the power of the contribution tax reduction, especially when wrongly sold as a 'benefit', is very strong. (Hopefully you have read the previous Nitty-Gritty page and know now that it is NOT a benefit.)
TFSAs have no carrot-and-stick effect. This may be good when you are saving for short-term purchases - moving money in and out regularly, but bad if you are saving for retirement.
- Re-using Contribution Room - Contribution room for RRSPs can be used only once. In contrast any withdrawals from a TFSA can be re-contributed the next year. So savings can be put in, taken out and spent, and more savings used to replace those original contributions. This makes the TFSA the best account when saving for expected short/medium term purchases. RRSPs are best for long-term planning, where savings go into the account and never come out until retirement.
- Creditor Protection - RRSP assets are protected from the claims of creditors. The RRSP is a trust structure that is legally considered another 'person'. A TFSA does not have this protection.
- Collateral for Loans and Interest Deductible - RRSP assets cannot be used as collateral for personal loans. For anyone wanting to use leverage investing this is a problem. TFSAs can be used for collateral.
- Tax Rate on Withdrawal - The RRSP's Bonus (or Penalty) created by a lower (or higher) tax rate at withdrawal is discussed fully on the RRSP Nitty-Gritty page. This is the main difference in benefits between the two accounts. Because that future withdrawal rate is unknown the RRSP's benefits are more risky than the TFSA's. Your objective in any choice between the accounts is to maximize any bonus or to minimize any penalty.
- Other Government Programs - For TFSAs neither contributions or withdrawals hit your tax return. They never impact your qualification of different government support programs. But contributions to RRSPs decrease reported income and may increase benefits from the Child Tax Credit and GST Credit. Withdrawals from RRSPs in retirement increase reported income and reduce income-tested benefits like OAS and GIS.
The clawback of these benefits has a huge impact. It is not the clawback of OAS that matters to the vast majority of us. It is the clawback of the GIS. The outcomes using a TFSA are most always better than from an RRSP when your contribution were from the first tax bracket. See this Save In RRSP or TFSA spreadsheet that models the two choices for a 35 year old expecting to retire at 65 with normal government benefits.
- US Dividends - The tax treatment of US dividends differs between RRSPs and TFSAs. RRSPs are considered retirement vehicles under which tax treaties allow no tax withholding on distributions crossing the border. But TFSAs are not in this class. 15% taxes will be withheld. There is no mechanism for getting it back. In a normal taxable account, you recover the taxes paid on your income tax return. But you file no income tax return for your TFSA. The withholding is a permanent loss.
- Moving To Another Country? - The RRSP, as a pension plan, and income from it, may get preferential tax treatment by your new country. Leaving the RRSP account active when you move will not affect the determination of whether you are (or not) a resident for tax purposes. In contrast, the income earned in a TFSA, and withdrawals, may be considered taxable by your new country although they remain un-taxed by Canada.
- Taxes on Death - On death, both accounts can continue earning profits tax-free in the hands of the surviving spouse. Otherwise the accounts are collapsed. There is no tax effect for TFSAs but the whole RRSP account becomes income in the year of death. If the RRSP is large it may use up all the lower tax brackets, with lots taxed at the top rate. Stipulating a named beneficiary for both accounts means that person receives all the assets from the account and the account is not included in the estate that is subject to probate taxes. The RRSP withdrawal taxes are paid by the remaining estate. Only when there is not enough money in the remaining estate to pay the RRSP withdrawal taxes can the government come after the beneficiary of the RRSP for those taxes.
- Income Splitting -
* There is no problem giving money to family, for them to put in a TFSA. Since the income is not taxed the Attribution rules do not apply. But money given to a spouse to contribute to the spouse's own RRSP, with the deduction claimed by the spouse at the spouse's tax rate, does trigger Attribution. The profits inside the plan remain tax-free, but the eventual withdrawal is taxed in the hands of the lender.
* Direct contributions to a spousal RRSP uses up the contribution room of the donor, and generate the tax reduction based on the (higher) tax rate of the donor.
* Withdrawals from an RRSP after the age of 65 qualify as 'pension income' and can be split as wished between spouses. This can significantly lower the effective withdrawal tax rate discussed in (7.) above.
* Withdrawals needed before the age of 65 (that don't qualify as 'pension income') are effectively income-split if taken from a Spousal RRSP.
* If you believe there is a benefit from raiding RRSPs to fund a home purchase, you can double up the $25,000 withdrawal if both marriage partners use the Home Buyer's Plan.
- Limited Time Span - Wealthy people may not need money from these accounts for retirement spending, The TFSA may be their better option because savings can stay in the account until death. In contrast, the RRSP's required withdrawals limit how long savings can stay protected. Any required withdrawals from an RRIF that are not needed for spending, may continue to be sheltered from tax if moved into a TFSA. Whether there will be contribution room in the TFSA depends on your personal assumptions. Be sure to ask what assumption was made if someone else models the scenario. Different assumptions are modeled in the Collapse RRSP Early? spreadsheet.
- Timing of Tax Receipts - From society's point of view savings for retirement are better in an RRSP. Older people draw larger social benefits. Those are better financed by delaying tax receipts during working years, and collecting larger receipts in the later years when the social cost is higher. Hopefully the rate of return you earn in the account is larger than the interest rate the government pays on its debt, so there is a net benefit to the government from the delay in collecting the tax. Here is a spreadsheet calculating the net cost to taxpayers of RRSP from the POV of the government.
RESP or RRSP ?
The Registered Education Saving Plan (RESP) allows you (the settlor) to fund an account to be used for your children's higher education costs. Helpful government sites cover the rules and regulations here and here . Contributions are made with after-tax money, like a TFSA. The government gives you a 20% matching grant on a maximum $2,500 contributed per year (that is $500) up to a maximum $36,000 per child (that is a $7,200 grant). Profits earned in the accounts are not taxed - like both the RRSP and TFSA. However those accumulated profits are taxed when withdrawn - unlike either the RRSP or TFSA. Profits (along with the grants) are taxed as income of the student whose tax rate will hopefully be 0%, making the profits permanently tax free.
Withdrawals from an RESP can cause family strife. Both the student and the settlor can withdraw funds as long as proof is given that the student faced educational expenses. Account providers sometimes require both parties to agree, but at least they should issue a notification to the student when the settlor withdraws funds, because the student will face additional taxable income at year end. The student may miss that notification and be irate over taxable income they knew nothing about, and which they may have never received. They may have personally paid all those educational expenses, and never been repaid from the RESP draw.
- Remember that you cannot multiply benefits by putting some money into an RRSP, and then using the refund to fund a RESP. This line of reasoning is wrong because the RRSP's contribution tax credit is not a benefit - it is a loan. Hopefully you will have learned that from the Nitty Gritty webpage.
- The RESP's 20% matching grant cannot be compared to an RRSP's contribution tax credit. You often hear experts wrongly making this comparison. The RESP grant is a benefit if the student pays 0% tax on withdrawal - otherwise it is income. The RRSP contribution credit is a self-financing loan.
- If the contributor has $36,000 cash to contribute to an RESP, is it better to contribute the full amount as soon as possible to maximize the benefit of the tax-free compounding of profits, or to delay contributions of $2,500 per year for 14 years in order to get the maximum yearly grants? The answer is ... It is always better to delay the contributions and maximize the grants when the cash will alternately be invested in a TFSA or RRSP.
If the excess cash will be invested in a Taxable account then the optimal choice depends on your assumptions about rates of return and tax rates. You can play with the numbers yourself with the RESP or RRSP spreadsheet.
- Should you use an RRSP or an RESP when you cannot afford both? There are risks either way. The RESP 20% matching is a certainty, but the RRSP may give a 20% Bonus if withdrawn at tax rates 20% lower. Both accounts shelter profits from tax while in the account, but the RESP income risks being taxed on withdrawal.
- The choice between RRSPs and RESPs changes when the student faces taxes. This may be because he has a summer job or because he works an apprenticeship term. Both the profits and the grants are taxed as income at full rates. Whether the accounts would be fully funded at the start vs. yearly contributions, determines which account is better to use. Assuming the student is taxed at the bottom 22.5% tax rate, the RESP is the better account when funded with yearly contributions. The RRSP is better when the maximum contribution is made at the start. This is because the profits that benefit from sheltering are larger then.
- The analysis in (5) above presumes that RRSP savings can be withdrawn at the same tax rate used for contributions. But when your child enters university you are probably in your peak earning years - at your peak tax rate. When you face an RRSP penalty from withdrawing at a higher tax bracket, and the accounts would be fully funded at the start, and it is likely the student will pay 22.5% tax, the choice swings more in favour of using an RESP the larger the increase in tax rates and the lower the rate of return earned. You need to use the spreadsheet to factor in all these variables.
Borrow For An RRSP Contribution?
Everyone in the investment industry benefits from RRSP season.
There is a great deal of hype and pressure to get the deal done before the
deadline. The industry knows that once that deadline is past, your
probability of contributing shrinks drastically. SO OF COURSE they tell you to borrow if necessary. This advice is now gospel
for everyone, regardless of tax bracket and investment returns and interest
The most common argument is "You can use the resulting tax refund to
pay back the loan in a month or two". They don't tell you that at the
tax bracket only 45% can be paid off by the tax refund. At the 25% tax bracket only 25% of the contribution can be paid off by the tax refund. They don't
tell you what to do with the remaining 55% or 75% of the debt. Since you were
unable to save the required amount beforehand, it is very unlikely that you will
be able to pay off any debt that exceeds the tax refund. Rule: Never borrow more than your expected refund. Calculate that refund by doing a pro-forma tax return. Don't rely on a math calculation.
Others argue for borrowing by expounding on the benefits of tax-free
compounding within the RRSP, and other valid (or not) RRSP benefits. These don't pertain to the question at hand - "Should you borrow to fund the contribution?". They pertain to the question; "Should you invest inside or outside an RRSP?".
Another argument is that you should borrow to fund a contribution in
years when your marginal tax rate is high ... and withdraw the money
the next year when your tax rate is low, to repay the debt. Your benefit from the
different tax rates will more than offset the cost of borrowing.
This argument works in theory, but permanently destroys 'contribution room',
and forsakes the RRSP's long-term benefit of tax-free compounding and growing wealth.
A fourth argument heard is "If your RRSP is your only savings account, then you are better to borrow for contributions and to pay cash for consumer purchases that you otherwise intended to use borrowed funds to buy". This argument is nothing but re-branding of an obnoxious product - consumer debt. The better advice is "Don't buy consumer goods until you have the cash to pay for them". Savings are what is left AFTER you pay for your purchases. If you have the cash for the purchases, but no extra for savings, then pay for the purchases. Undertake to spend less and save in the future.
The prime argument AGAINST borrowing is that there is no reason to
wait for your tax refund.
• You can tell your employer that you will be
making RRSP contributions. She is obliged to reduce your payroll taxes
withheld throughout the year. Your larger pay cheques allow you to fund
your contributions in cash, AND fund them six months earlier than if
you borrowed against a refund. Form T1213.
• Or you can schedule large once-yearly expenses like insurance to be paid with the tax refund. Because you need not save up for this expense you can contribute more to the RRSP instead.
• Or you can drawdown your emergency fund to top up the RRSP contribution and replenish it a few months later with the refund.
Borrow INSTEAD Of Using An RRSP
During RRSP season, you may hear the idea that you can duplicate the tax-protection of an RRSP (or TFSA) by borrowing money to invest outside of tax shelters. It may not be a good idea. Assuming you now know the main benefit of RRSPs is their zero tax on profits, you will understand this is the same objective here. Investment income like capital gains and dividends are taxed at preferential rates, about half the rate applied to interest. The tax recovery from $x debt interest will equal and offset the tax bill from $2x capital gains.
|$10,000 invested||at 5% =||$500 income,|| times 23% tax rate =||$115 tax expense|
|$5,000 borrowed||at 5% =||$250 expense,|| times 46% tax rate =||$115 tax saving|
|= $5,000 in RRSP||at 5% =||$250 income||tax-free =||$0 tax|
Heck, when using leverage you would demand investment returns waaaay larger than the cost of debt. Using the example above, if the cost of debt is reduced to 2.5%, both the interest $expense and the $tax recovered are cut in half. The resulting $5,000 net investment earns $375, pays a net $57.50 tax bill and comes out even further ahead with $317.50. Why would anyone use RRSPs (other than high income earners who will benefit from a lower tax rate on withdrawal)? There are problems.
- Leverage kills, regardless if taxation works to your favour, because when investing with leverage, emotions trump math every time. It is pointless to consider long-term average returns, because your decisions will be governed by short-term emotional responses. Using the example above, if the investment earns only 4% (not 5%) you end up with less than if you used an RRSP. In fact you end up with less than if you had simply invested without leverage and paid all your taxes in a Taxable account.
- Most people using leverage try to reduce volatility by sticking to safer investments. But this strategy won't work when safe bonds are owned. They generate interest income that is fully taxed. This won't work with REITs because their operating profits are fully taxed. This won't work with high dividend foreign stocks because their dividends are fully taxed.
- Interest rates change. They may be low at the start of economic recoveries so leverage is great. But rates will be high at the business cycle peaks, just before investments crash - leaving you with big interest expenses matched by investing losses. In contrast, the RRSP is a plan for all seasons, for the long run.
- Ask yourself if you would use leverage to invest otherwise. The 'leverage issue' is much more important than the 'tax issue'.
People pushing this idea may extend their reasoning to the idea of borrowing for an RRSP contribution. This strategy WILL NOT WORK in that situation because the loan's interest is not tax deductible. The author is doing a 'bate and switch'.
HBP - The RRSP's Home Buyer's Plan
The government allows savings within an RRSP to be used for the purchase of a home. There are two different mechanisms. The HBP Home Buyers' Plan allows for a cash withdrawal, and the basic list of Qualified Investments Folio S3-R10-C1 includes mortgages. This article refers to the HBP. To reduce your commercial mortgage, you withdraw a maximum of $25,000 from your RRSP and repay it over 15 years (these regulations change).
The benefit of the HBP equals the income you earn (interest expense you save) on the normal withdrawal taxes NOT paid on the HBP withdrawal, before it needs to be repaid. If $25,000 is withdrawn, the withdrawal taxes not paid at a (say) 30% tax bracket = $7,500. If the mortgage interest is 3% and the cash is used to reduce that mortgage, then the benefit is $7,500 * 3% = $225 in the first year.
The benefit is not from an interest-free loan of the entire $25,000, as many claim. If left inside the RRSP that $25,000 would be earning profits in some other investment. When used to reduce your mortgage you give up those profits. Consider the gain and loss of profits to offset each other. Since the 30% of savings in an RRSP is 'owned' by the government, you only benefit from your 70% portion of the profits earned. (You already know this from the Nitty-Gritty page). The HBP allows you to claim 100% of the profits earned. So the incremental benefit is only the profits earned by the 30%.
A superficial understanding of the idea leads people to ignore all its problems. You are 'borrowing' from yourself. How innocuous is that? You get the use of the $7,500 interest free. How is that not a good thing?
- A better point of view is to consider the debt NOT to yourself, but to the government. Any non-compliance with the rules will trigger tax charges exactly at the time when you are short of cash (since you could not make the repayment) and loss of RRSP contribution room. The government holds all the cards. You cannot even escape by claiming bankruptcy.
- The dollars you withdraw were originally saved with the help of the RRSP contribution tax credit (out of before-tax income). If your marginal tax rate on the $25,000 contribution was 30%, you only needed $17,500 after-tax savings. The dollars to pay back to the plan will not trigger any tax deduction. You will need $25,000 additional after-tax savings. It will be harder to repay the plan than it was to save the original amount.
- There will be annual overhead costs for the plan's administration.
- You should always consider divorce. The family home has special rules attached. Having part of its mortgage sitting in one spouse's RRSP makes things more complicated.
- Commercial lenders calculate the safe amount they can lend you so that your debt servicing costs are affordable. These calculations are valid limits to what you should borrow. You are adding the RRSP loan on top of that (= a second mortgage). If your commercial loan is for the maximum they will lend you, you are pushing your servicing costs beyond what experience says is safe.
- You face this second mortgage at a time when your living costs have suddenly gone up, and you can least manage more claims on your cash flow. An article in Maclean's magazine quoted governments statistics showing that half HBPs in 2013 failed to make the required repayments.
- Yes, that $25,000 may make your down-payment large enough to prevent having to pay CMHC insurance. That is a valid benefit. But that $25,000 may also be used to justify the purchase of a home that is ($25,000 / 20% =) $125,000 more expensive. Are you going to buy 'more house' just because you can get your hands on the money? Many will, even though this is rarely a valid reason.
- Most people using this plan are young and probably at a lower tax bracket than they will be later in life. By contributing to an RRSP just to use the HBP, they are increasing the probability of paying the Penalty from eventual withdrawals at higher rates (see Nitty Gritty page). The difference between Canada's bottom two tax brackets is 33% - 22.5% = 10.5%. The cost of contributing at the lower rate would be a growing/compounding penalty $25,000 * 10.5% = $2,625.
You may hear advice to use the HBP anyway, even when not needed to reduce your mortgage. The $25,000 would be used for investments just as it would be inside the RRSP. But the math shows you keep more of the profits (on the 30% that would otherwise be 'owned' by the government). The idea is the same as taking out student debt when not needed, and investing it for four years while it is interest-free. How can you lose when leveraging with interest-free debt? Because investments go up and down in value, there is no guarantee the investments will cover the cost of repaying the debt. The counter argument is that "Markets always recover within a five year time span, so there is no risk of loss". But markets are not constrained by what has happened in the past. There are no guarantees. More importantly, there is no 'long-run' when leveraging. Leverage augments your emotional responses to market drops. Your self-assured claim "Don't worry, I'll just buy and hold" may be famous last words.
Save for your home in TFSA instead. The major benefit from saving for a down-payment in a TFSA instead of an RRSP is the KISS directive (Keep It Simple Stupid): no rules, no penalties, no second mortgage with ongoing cash requirements, no administration fees, no time wasted keeping track. Even saving for the down-payment in a taxable account is not a bad idea for young people in the bottom tax bracket.
Problems with US dollar transactions for Canadians
There are four issues that must be addressed in order to decide whether it is better to hold US securities in an RRSP (vs a TFSA or a taxable account) - (1) the marginal tax rates applied to US source income in taxable accounts, (2) the transaction costs of converting cash between Loonies and Dollars, (3) foreign withholding tax, and (4) foreign income earned by structured products. You can use Where Put US Securities spreadsheet to input your own assumptions and calculate an after-tax net rate of return for each possibility.
- Start by looking up your own marginal tax rate for each type of income on this Marginal Tax Rates spreadsheet. In taxable accounts interest income and dividends from foreign countries are taxed in Canada exactly like Canadian source interest - at full rates. 15% will be withheld at the border.
Capital gains on foreign securities are treated the same as all other capital gains and included on the income tax return's Schedule 3 list. Only half the gain is considered taxable. There is no withholding tax. Remember that many investments generate profits from a combination of interest, dividends, capital gains and foreign exchange rate changes. You must pro-rate their different tax effects.
- Many Canadian brokerages do not allow you to hold US dollars inside an RRSP or they charge you an ongoing fee for the privilege. The government allows it but the brokerages claim there are technical problems. The result is that all US dollar transactions (distributions received, purchases, sales) get settled in Loonies and incur a fee for swapping between Loonies and US dollars. The fee will be hidden within the exchange rate they give you. Depending on the size of the transaction and your broker this can be between 1% and 2%. When you sell one US security and buy a replacement you incur the fee twice. Some brokerages allow you to make a special request to cancel the fees if both the sale/purchase are done the same day and for equal values. How long you hold an individual security determines how frequently you trigger the fee with purchases and sales .
- Distributions of interest and dividends out of the US have 15% withheld according to treaties. In taxable accounts this is not a problem because you recover the amount on your personal tax return. You must only remember to claim the taxes withheld as an offset to your Canadian income tax liability. Don't forget to claim the provincial portion as well.
The US treaty allows dividends and interest going into pension-type accounts to NOT have this tax withheld. So RRSP accounts should not have any withholding, but TFSAs will - because they are not pension-type accounts. If your broker is wrongly allowing US withholdings inside your RRSP it is probably because they have not filed the necessary form (W8BEN).
The 15% withheld in a TFSA is not recoverable. It is a permanent loss, but remember that it is just 15% of the (say) 4% dividend. That is a reduction of only 0.6% from the asset's rate of return. If earned in a taxable account that income would be taxed at more than 15%. Still, US interest and dividends are better received into an RRSP with no withholdings tax (all else equal).
Each foreign country has different rules and a different treaty. Many are the same as the US-Canada treaty but that should not be 'just assumed'.
- Foreign profits earned within structured products like mutual funds and ETFs create a whole different level of complexity. If the product itself is foreign (e.g. foreign listed ETFs) then the situation is predictable. The product declares what type of income is being distributed. As it crosses the border taxes are withheld from TFSAs and taxable accounts but not RRSPs - in the same way as discussed above.
When the distribution-paying security is owned inside a Canadian-issued product, all distributions crossing the border have 15% withheld. The Canadian product issues tax slips at year end to pass through these items onto your personal tax return. But RRSPs and TFSAs throw out the slips because they file no income tax return - they have no way to recover the withheld tax. So you lose the withholdings in both RRSPs and TFSAs.