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.
........... Is this Asset Location? ....................
This issue and the math process shown above relates only to the Asset Allocation process of choosing a risk exposure. It has nothing to do with the Asset Location issue of maximizing tax benefits. Asset Location is discussed below. This confusion seems to appear within discussions about the valid point that ... investors looking at the changing values of combined accounts published by the brokerage, will 'see' and 'feel' more volatility than they theoretically should, when risky assets are allocated to the RRSP using the math above, and vice versa.
For an extreme example assume two accounts, RRSP = $2,000 and TFSA = $1,000. The brokerage reports a total $3,000 for all the accounts. The RRSP account faces a 50% tax for withdrawals, so only half its value is 'your money'. Total wealth is only $2,000. Two assets are owned (R is risky and T is safe). The preferred location for asset R is in the RRSP. The preferred Asset Allocation is 50 / 50. So all the RRSP is filled with asset R = $2,000, and all the TFSA filled with asset T = $1,000.
What happens when asset R in the RRSP drops in value by 20%? Since it is only a 50% weighting you would expect a portfolio drop of only 10%. The RRSP account holding only asset R drops in value by $400 to $1,600 and the brokerage reports a 13.3% total drop in value for all accounts (400/3000). But when the portion of the RRSP that is 'owned' by the government is ignored, the wealth in the RRSP only drops $200 to $800. The investor's wealth drops only 10% (200/2000). Investors who uses this AA math experience more volatility than they signed up for - more then their factual reality.
| ||Start||R drops 20% ||Change |
| ||stockR||stockT||Total ||stockR||stockT||Total || |
|RRSP ||$2,000||$2,000 ||$1,600||$1.600 |
|TFSA ||$1,000||$1,000 ||$1,000||$1,000 |
|Broker ||$2,000||$1,000||$3,000 ||$1,600||$1,000||$2,600 ||13.3%|
|Wealth ||$1,000||$1,000||$2,000 ||$800||$1,000||$1,800 ||10%|
Does this matter? An investor's risk tolerance is tested very rarely in extreme markets. All the rest of the time, the apparently higher (or lower) price volatility makes no difference to the investor. In market crashes though investors should control their knotted stomach by noting their total wealth alongside the broker's total (ie. discounting the RRSP account) .... a tiny effort to remind themselves that reality is not so dire.
........... More math. Discount the Taxed account? ....................
For those of you looking for an excuse to not shovel the driveway, there is yet another issue connected to 'Asset Allocation Math'. You will find some sites claiming that, just like you discount the RRSP's value by the withdrawal tax rate, so too you should discount the Taxed account by the tax rate on investment profits. Long story short - their argument is false. If you really want to hear it, and where it errs, there is a separate page called "Discount Taxed Account?"
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. If a mistake is made one option is to withdraw the funds immediately, but then the $2,000 becomes taxable for a second time, once when earned and again now when withdrawn. The far better option is to wait until the contribution room has been earned, and then claim the tax deduction as soon as possible.
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 the better. But this situation is no different from that discussed immediately above - the choice to delay claiming allowed deductions. They are recommending the third option - to contribute but delay claiming the deduction. Your only other option is the first one - to leave the funds in a Taxed account and pay the income tax on profits. Compare the outcomes calculated in the table above. It is always better to leave the funds in a Taxed account. The experts' advice is wrong. It needlessly creates a Penalty from Delay that is greater than the Benefit from Profit Sheltering.
|Account ||Taxable ||RRSP |
|After-tax savings in 39% tax bracket ||$2,000 ||$2,000 |
|Grows at 8%, Taxed at 21.1% |
with 50:50 dividends: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 |
Pay Down Debt Or Contribute To An RRSP?
Every year in RRSP season the media asks the question "What should you do with your extra cash - pay down your mortgage, or put it into an RRSP?"
The answer always given is "Put it into an RRSP and use the refund 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 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.
Now that you understand the RRSP system you should know what the error is. The argument is based on the false idea that the RRSP refund is a 'benefit'. You are meant to believe that you can double up on the benefits. All this actually accomplishes is to allocate some savings to each choice - when one choice (or the other) is better for you. This outcome will always be sub-optimal.
Many articles pushing you to keep debt while contributing to an RRSP base their reasoning, not on anything specific to RRSPs, but on the general argument that "You should invest with leverage because your investment returns will be higher (on average) than the cost of debt" . The decision to not repay debt, in order to invest with savings, is the same as the decision to borrow to invest - to leverage.
But luck won't always serve up high investment returns. Higher returns are only expected when there is the risk of loss.
Assurances that of course you have the stomach to ride out down markets, may be forgotten during the real event.
Your investment portfolio will probably include safe bonds earning a lower return than your debt, creating losses on the difference each and every year.
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. Your tax rate for draws may have increased creating the Penalty from withdrawals at higher rates.
Most often this issue arises in the context of extra savings while still repaying a mortgage. In this scenario there will be yearly savings, not just a one-time lump sum of cash. Yearly cash flows create 'sequence of return' risk. In order for investing to be the better option it is not sufficient to earn a return, averaged over the investment period, that equals the mortgage interest rate. The ordering of yearly returns matters almost as much.
Compare the outcomes of yearly savings of $100 over 4 years. The mortgage interest rate is a steady 5%. Over 4 years the savings would have repaid $453 of the debt. Investments earning the same averaged 5% could accumulate $561, or $372. It all depends on the sequence of volatile returns. The returns earned at the end, when all the cash inflow are working, count more than the returns at the start.
| ||Mortgage ||Invest 1 || Invest 2 |
|year 1 ||5%||< 25% >|| 30.384%|
|year 2 ||5%||10%|| 13%|
|year 3 ||5%||13%|| 10%|
|year 4 ||5%||30.384%|| < 25% >|
|end value ||$452.56 ||$561.34 || $372.28 |
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 increase reported income and reduce income-tested benefits like OAS, GIS, GST and the Child Credit. Withdrawals may increase taxable income within the range of the 0% Personal Exemption .... but also decrease a spouse's ability to claim the Spousal Credit.
The clawback of GIS and OAS 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.
* A spousal RRSP allows the high wage earner to contribute to an account in the name of his spouse, using his own contribution room, and generating the tax reduction at his higher tax rate. Eventual withdrawals are taken by the spouse as her own income taxed at her lower tax rates. Since the creation of 'pension splitting' this strategy has little benefit except for withdrawals by the spouse before age 65 - e.g. when taking time off to raise children.
* 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. This can also nullify the Attribution rule effects from the high wage earner giving money to the low wage spouse to deposit into her own RRSP, using up her own contribution room, at her lower tax rate. This allow for the sheltering of more profits from tax. The eventual withdrawals can be split between spouses even though it is the high wage spouse that claims them. The benefit from profit sheltering will likely more than offset any penalty from a higher withdrawal tax rate.
* 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'.
The RRSP's Home Buyer's Plan (HBP)
The government allows savings within an RRSP to be used for the purchase of a home. There are two different mechanisms. The HBP allows for a cash withdrawal, and the list of Qualified Investments Folio S3-R10-C1 includes mortgages. This article refers to the HBP.
The Home Buyer’s Plan allows a maximum $25,000 to be drawn from an RRSP without paying withdrawal taxes. It is only a loan because the full amount must be repaid equally over 15 years. The benefit of the HBP essentially comes from the income earned by the withdrawal taxes NOT paid on the HBP draw, until repayment. E.g. for a $25,000 draw, at 22.5% tax, to reduce a 3% mortgage, the first year’s benefit is 25,000 * 22.5% * 3% = $169. You can play with your own input assumptions using the HBP spreadsheet
For clarity, consider paying-down a mortgage to be the same as growing an investment. Inside the RRSP, 22.5% of the $25,000 is 'owned' by the government, so savers keep only 77.5% of the profits. The HBP allows savers to keep 100% of the profits. The incremental HBP benefit is the profit earned by the 22.5% - the amount that would normally be taxed on withdrawal. This yearly benefit declines as the HBP is repaid and the outstanding loan shrinks. Note that the 3% benefit in this example took 15 years to accumulate – pretty tiny.
It can be argued that being able to access the $5,625 refund allows the home buyer to afford the 20% down payment on a home costing $28,125 more. But the counter argument is that because the HBP is essentially a second mortgage, the buyer probably should not buy the larger home because he really cannot afford it.
The HBP cannot be sold as ‘an interest-free loan’, implying that its benefit equals the income earned on the full $25,000 amount. This is not correct because if left inside the RRSP the $25,000 would be earning profits in some other investment. When withdrawn those profits are lost. Since paying down a mortgage is risk free, while investments inside the RRSP would likely to be more risky but earning a higher return, it makes more sense to simply consider the returns, inside and out, to equal and offset each other on a risk-adjusted basis.
The assumption in the example above, that the HPB repayment savings would earn only the same low rate as the mortgage, is probably not true for most people. They would invest in stocks to earn a higher return. Change the assumed rate of return to 6% and the HBP’s cumulative 3% benefit disappears. There would be no benefit at all no matter what tax rates you assume for RRSP contributions and draws. This is because each year’s $1,667 savings, when not using the HBP, increases your wealth by the same $1,667 and you get to keep all the profits earned by it in the future. But the $1,667 repaid into the RRSP only increases your wealth by the 77.5% of it that will be ‘your money’. Inside an RRSP you only keep the profits earned by your part of the account.
Other than having no benefit, the biggest HBP problem is that the young first home buyers attracted by this plan, are exactly the demographic that should be saving in a TFSA, not an RRSP. The miniscule HBP benefits are swamped by the larger difference in long term outcomes resulting from saving in the wrong account.
If you also change the expected future RRSP withdrawal tax rate to 39%, the HBP’s 0% benefit turns into a 8% loss. The 39% assumption for withdrawals is perfectly reasonable for contributors in the bottom tax bracket because of the GIS clawback effect.
The large default rate for HBP repayments shows that home buyers fail to appreciate how much cash a home can eat up. An article in Maclean's magazine quoted governments statistics showing that half the HBPs in 2013 failed to make the required repayments. Adding the HBP repayments on top of their mortgage pushes many beyond breaking. The tax on failures to repay means they cannot escape without some payment. The tax rate then can easily be higher if wages have risen since funding the RRSP - creating the penalty from RRSP withdrawal at higher tax rates. There is no flexibility to choose to default on all future repayment in any particular year you have low income.
Save for your home in TFSA instead. KISS (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.
Using the HBP for nothing at all to do with home buying can be justified for wealthy, high income people with TFSA room. These people can use the excuse of a new home to withdraw $25,000 to invest it in a TFSA in high growth assets. They get to keep all the profits instead of splitting them with the government inside an RRSP. If you change the assumed rates of return to 6% for both assets, and both tax rates to 39%, the HBP’s cumulative 3% benefit turns into a 8% benefit.
The only risk comes from the requirement to fund the yearly $1,667 repayment. Since high growth assets have variable returns, there needs to be other safe assets for funding the repayments.
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.