Nitty – Gritty of the RRSP Model

Americans – think IRA or 401k when you see RRSP, and Roth when you see TFSA

Why you should read this page.

Below is a detailed argument, supported by math, proving that what you probable understand about ‘how the RRSP system works’ … is wrong. It proves that the benefits of the RRSP don’t come from the factors commonly claimed. It proves that RRSPs have four independent factors that must be evaluated and calculated separately. The account’s benefit is the net of these factors.

Amazingly, no one before has bothered to calculate the benefits of an RRSP vs. a taxable account, or developed the math for calculating the cost/benefit of each factor. There are also issues not covered on this page. Each procedural rule could be considered a benefit or cost. See the list of attributes discussed relative to the TFSA on the RRSP Decisions page.

What are the mechanics of the RRSP system ?

Most Canadian know the mechanics of the RRSP system. The comparison following between an RRSP, TFSA and Taxable account is never disputed. It presumes that (i) when comparing the outcomes from using different accounts it is necessary to presume that all savings go into those accounts, (ii) when wages and living expenses are held constant between options, any option that reduces taxes should result in larger savings, (iii) the RRSP’s benefits accrue only to the dollars in the account.

• Wage income is normally taxed on your personal tax return. Savings going into a TFSA or Taxable account are after-tax savings.
• Contributions to an RRSP can be claimed as a tax deduction. The resulting reduction in $tax, calculated at your marginal tax rate, is the contribution credit. This allows you to save with before-tax dollars – to fund the account with more dollars.
• Inside all accounts the savings grow. Profit are taxed in the Taxable account so an after-tax growth rate is used. Both the TFSA and RRSP grow tax-free.
• Savings can be withdrawn from the Taxable and TFSA without any tax. The RRSP withdrawals are fully taxed at your marginal tax rate.

The example above uses one set of input variables, but no other choice would change the generally accepted statement that “outcomes from a TFSA and RRSP are equal when there is no difference between the tax rates at contribution and withdrawal”. No one doubts the TFSA’s benefit is from permanently sheltering profits from tax. The RRSP’s main benefit, the only one that everyone receives, is from the same permanent sheltering of profits. It will always exactly equal the TFSA’s benefit.

The math calculation of RRSP and TFSA benefits ($1,165) equals the difference between the future values of the after tax savings ($3,500) compounded for 10 years, at the nominal rate of return (10%) vs. at the after-tax rate of return (8.5%).

Profits not taxed – Ever

It is easier to understand why these benefits are always equal by deconstructing the RRSP account into two conceptual parts. Shown below, one part is funded with after-tax savings just like the TFSA. The other part is ‘the Difference’ between RRSPs and TFSAs. It is funded by the government.

The Difference column shows why the contribution credit (aka ‘the refund’ or the ‘tax reduction resulting from the tax deduction’ = $1,500) is never a benefit. Nor is there any benefit from deferral of tax. The contribution credit grows tax free, like the account in total, but its resulting value ($3,891) is what funds the withdrawal tax. The ‘Difference’ column is always completely self-financing and creates no costs or benefits.

The withdrawal tax is an allocation of principal. Think of it like your best friend Bob gave you $1,500 of his money to add to your $3,500 investment account – for you to manage as you wish. At the start Bob’s $1,500 was 30% of the resulting total. He continues to ‘own’ 30% of the account, and takes back his 30% of its resulting value ($12,969) when the arrangement is finished. You neither gain nor lose from the arrangement.

Or think of the Contribution Credit like a loan from the government. The withdrawal tax is the loan repayment, along with all the income it earned. There was no benefit from a deferral of tax because all the income earned by the tax reduction on contribution goes back to the government on withdrawal.

The RRSP’s main benefit comes from what happens in the left column, where your after-tax savings grow tax-free and stay tax-free on withdrawal. None of the profits inside the account are ever taxed, not your portion or the government’s, but you only benefit from the sheltering of your own portion.

This shelter from profits disproves the somewhat-common claim that “You can replicate the benefits of an RRSP by holding assets without ever selling, so that capital gains are only paid decades later.” A deferral of taxes does not replicate the RRSP’s zero% taxes. Compare outcomes using the assumptions in the first box above where the different accounts are compared. Keep the RRSP assumptions the same. Change the growth rate in the Taxable account to be tax-free at 10% for 10 years, and capital gains taxed at a preferential 15% only at the end.

RRSP profits are permanently tax free, and tax free is always better than taxed, even when deferred and at preferential rates.

No benefit from deferral of taxes.

It is common to hear: “The RRSP’s benefit is from deferring tax. A dollar today is worth more than a dollar tomorrow, so there is a benefit from the delay”. But there is no benefit from deferring payment of a liability unless the income you can earn in the interim is greater than any increase in the liability. There is no benefit from the deferral when your $100 bill can be paid today or

• invested at 10% but your bill becomes $110 at the end of the year, or
• invested at 20% but your bill becomes $120 at the end of the year, or
• invested to lose 5% but your bill becomes $95 at the end of the year.

This is the same situation in the RRSP. Your liability for the tax on wages that you didn’t pay at the start, grows at the same rate as your investment returns. You end up no better off from the deferral. This shows in the middle column of the model. The taxes paid on withdrawal equal the all the original credit plus all the income it earned.

The contribution’s tax deduction is not a benefit.

All the official sites falsely claim that the major reason to contribute to an RRSP is “to get the tax deduction” i.e. to receive the contribution credit. The bigger the tax refund the better. You are told that you will have more savings earning more profits as a result. This thinking causes you to accept the face value of the RRSP account, and think it is all ‘your money’. By now you should know that the contribution credit is never a benefit. It is a loan, not a gift. It is your best friend Bob’s money he has given you to invest for him.

A bigger contribution credit means you have actually saved less $$. A $10k contribution generating a $4k contribution credit means the person has really only saved $6k. The same $10k contribution generating a $2k contribution credit means the person has really saved $8k. $1,000 saved does NOT equal $1,000 saved – not between RRSP and TFSA accounts, and not between individuals at different tax brackets.

The illusion of this ‘value fluffing’ of the apparent size of an RRSP can be a problem, especially for people contributing at the top tax rate. For them, almost half the portfolio’s value is due to the ephemeral credit. When periodically calculating your net worth, you should subtract a rough estimate of the taxes you must pay on withdrawal. Exactitude is not necessary.

The fluffed-up value in the RRSP leads to errors in asset allocation when assets are held in multiple account types. The RRSP wealth to be allocated should not be measured at it’s account value. The estimated withdrawal tax should be deducted. See the discussion on the RRSP Decisions page.

The illusion of this ‘value fluffing’ causes people to think they can game the system. They contribute free cash into an RRSP, then use the tax credit to fund a TFSA. They wrongly think they have magically grown their savings.

The claim that ‘the contribution tax credit is a benefit’ leads to various wrong financial decisions;

• when choosing which type of account to save in – TFSA (no c.c.) or RRSP (gets c.c.),
• when choosing between paying down a mortgage vs. contributing to an RRSP – thinking the RRSP c.c. can repay the debt and kill two birds with one stone,
• when deciding to borrow the cash for a contribution – thinking the tax reduction will cover the interest of debt,
• when comparing the value of tax reductions for charitable donations (true benefit) vs. an RRSP’s c.c.(no benefit).
• when arguing the merits of government’s social policy regarding pensions, by counting the RRSP c.c. as a social cost instead of as a loan.
• when comparing the RRSP’s c.c. (no benefit) to an RESP’s 20% matching contribution from the government ( true benefit) .
• when thinking that an RRSP’s c.c. would offset taxes on investment income in a taxable account – making that income tax-free – but ignoring the taxes due on withdrawal.
• etc.

What happens when tax rates change ?

When the tax rate at withdrawal is different from the rate at contribution, the RRSP creates a bonus or penalty, depending on whether the rate is lower or higher. By lowering the withdrawal tax rate from 30% to 20% in the next example, a bonus is created equal to 10% of the $12,969 withdrawn. The math to calculate the Bonus/Penalty is …

= the amount withdrawn multiplied by the change in rates.

The total taxes paid on withdrawal can be thought of as the sum of (i) the tax levied at the contribution’s tax rate, plus (ii) the tax levied at any difference in rates. This explains why the RRSP’s main benefit from permanently sheltering profits (above) remains true always. The $3,891 portion is fully funded by the original contribution credit.

The difference in tax rates can be influenced at either end. You try to time your contributions to be at a higher rate, and you try to time your withdrawals to be at a lower rate. But be clear that just because you try to maximize the contribution credit does not mean the contribution credit is a benefit in itself. It is the difference in rates that generates the bonus/penalty.

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The effect from changing tax rates is the major difference between TFSAs and the RRSPs. Rate changes have no effect on a TFSA. It is informative to calculate the RRSP’s penalty/bonus as a percent of the resulting wealth from using an TFSA. In the situation above, the RRSP’s bonus from a lower withdrawal tax rate resulting in 14.3% more wealth. The formula is

( Change in tax rate % ) divided by ( 1 minus tax rate on contribution )
10% / ( 1 – 0.30 ) = 14.3 %

Play with the variable inputs for the ‘Tax Rates’. You will see that a same 10% difference in rates has a greater RELATIVE impact on people at the higher tax brackets. This is because the bonus is calculated on the account’s balance – which will have been fluffed-up to a greater extent for high tax bracket earners. This makes contributing into a spousal plan (where the spouse will be withdrawing at a lower tax rate) more powerful for high wage earners.

This possible bonus is a very regressive tax effect. The government could get rid of this problem simply by taxing all contributions and withdrawals at the bottom tax bracket’s rate. Even during the pension reform discussions after the 2008 credit crunch there was NO discussion regarding this regressive tax or calls for change. It is likely that policy was written specifically to benefit the high income earners while hoping the poorer classes never find out.

Reconcile the different RRSP understandings.

Many readers will still be arguing that the traditional way of looking at the RRSP makes more sense to them. There is a generally accepted list of RRSP benefits from which individuals and organizations feel free to pick and choose. The government sites, publicly-paid education sites, and industry sites all choose from the following claimed benefits.

1. The tax reduction on contribution is a benefit.
2. Profits are only tax deferred (meaning not taxed at the time, but fully taxed at full rates on withdrawal).
3. The deferral of taxes is a benefit. (Tax ‘on what’ is unstated – on the original wages.)
4. A highly-likely lower tax rate on withdrawal (than at contribution) creates the RRSP’s benefit.

The analysis above dis-proves those claims.

1. The tax deduction is never a benefit. The tax savings at contribution fund the eventual withdrawal tax.
2. Profits earned in the RRSP are never taxed. The withdrawal taxes are an allocation of principal, not a tax on profits.
3. There is no benefit from deferring taxes on the original wages because the liability for withdrawal taxes increases at the same rate as the returns earned by the assets.
4. Below it will be argued that there is no probability, much less guarantee, that tax rates on withdrawal will be lower. A higher rate will create a penalty.

Where do they go wrong? In their model the withdrawal tax is applied to the total $12,969 withdrawn – which itself is the sum of the original $5,000 contribution plus the $7,969 profits earned. So both the contribution and the profits are taxed on withdrawal. Therefore profits are taxed on withdrawal. Case closed.

Not so fast.

If the withdrawal tax includes the $1,500 tax on the original $5,000 contribution then the first claimed benefit must be wrong. The $1,500 contribution credit is the tax not paid on the contribution. It cannot be a benefit if the same $1,500 is paid back on withdrawal. Together they always have a $0 impact.

What about the claim of benefits from the deferral of that tax? The value of deferral equals the profits earned in the interim. In this case the $1,500 contribution credit earns $2,391 before it is repaid on withdrawal. But this claimed benefit will always exactly equal and offset their model’s $2,391 ‘tax on profits’. Together they always have a $0 impact.

It is common to hear a defense of the ‘benefit from deferral’ along the lines of … “There is a benefit from deferral of taxes because you will be in a lower tax bracket at the later withdrawal date”. This argument tries to justify the false claim of a deferral benefit by using it as a label to describe the bonus from a lower withdrawal tax rate.

The word ‘deferral’ refers to the passage of time. If there is a benefit from deferral then that benefit must increase with time, but … (i) The only way to explain the penalty from a higher withdrawal tax rate would be if time moved backwards – unlikely. (ii) The size of the bonus from a lower withdrawal tax rate does not increase with time. A 20% bonus can be created within one year at the point of a change in marginal rates. Or, no bonus or penalty may result even after 50 years when tax rates don’t change.

The industry’s model fails to explain any benefits because some RRSP steps always cancel out each other. Most importantly their model totally ignores what is happening in the left column where profits are permanently sheltered from tax – the only benefit that everyone gets. Their model fails.

All the industry players have been challenged to disprove this website’s logic and math, and to provide the math to support their own claims. This list includes the big banks, the Investor Education Fund, the Get Smart About Money website, the Financial Consumer Agency of Canada, Investopedia, the Competition Bureau of Canada, the issuers of the CFP designation, the CAs, the Canadian Bankers Association, and Ryerson University. None have attempted the challenge. They simply ignore, dismiss and stonewall.

What are the unknowns that will determine a tax rate change ?

The effect (positive and negative) of a change in tax rates is an unknown until the time of withdrawal. It is a risk. Anyone telling you that you will certainly withdraw at lower tax rates is a snake-oil salesman. The only people in a position to ‘assume’ a bonus are those contributing at the top marginal rate.

One way to deal with the unknown withdrawal tax rate is to make it the ‘conclusion’ instead of the ‘given’ in your analysis. Make your best guess for all the other variables, then play with the withdrawal tax rate variable until both choices are of equal value. Then ask yourself “what is the probability of the future tax rate being larger/smaller than that variable?”

Some people say you should never assume your tax rate will rise on withdrawals because you could always withdraw the funds first, before your rates rise. There are two problems with this. First, most of the unknowns listed below will be unknown until they happen – too late. Second, withdrawing funds early would be shooting yourself in the foot – taxing decades of future profits, when they could have been tax-free.

Other people claim you should never assume your tax rate will rise because you should stop working and amassing wealth before that happens. Do you really need to told how silly that argument is? Some people will spend $100 to save $1 in taxes.

Variables that determine your tax rate on withdrawal….

1. Your total income when withdrawing.
   • When you die the total RRSP balance gets taken into income in one year. That can push a lot of it into higher tax brackets. The bigger the account, the bigger this problem.
   • Large draws can push you into higher tax brackets. E.g. if you need money to pay for long-term care, or to take an around-the-world cruise.
   • Couples with one spouse earning little income can lower the tax rate rate on RRSP draws by splitting the reported income between the two.
   • Many heavy users of RRSPs also have defined benefit pensions that replace normal wages. Incremental RRSP draws in retirement are taxed at the marginal rate above that pension.
2. The size of your RRSP account.
   • The more you save the bigger the resulting fund and the larger the required draws.
   • The larger profits earned by your savings, the bigger the fund at retirement.
3. Your savings in a Taxable account will generate profits that push your marginal RRSP draws higher in the tax structure.
   • You inherit a large sum.
   • You realize a large gain from the sale of your principle residence.
   • You realize profits from flipping real estate.
   • You amass poker winning.
   • You arrive as an immigrant with wealth.
   • Your qualifying Earned Income is small, but you save extra because you are thrifty.
4. Government programs.
   • Any income received from Canada Pension Plan, Old Age Security, etc, should be considered as taxed first at the lower rates. The greater the government benefits, the higher in the tax structure RRSP draws are pushed.
   • Government programs providing income assistance in retirement (GIS, OAS) have clawback provisions that reduce those benefits when your income exceeds certain limits. This has the effect of increasing the effective marginal tax on any RRSP withdrawals.
5. Tax rates can be changed by the government at any time.
   • The general economy, government deficits, and aging populations will determine political realities. Someone will have to pay.
   • The power of lobby groups to influence tax decisions may wane.
   • The width of tax brackets (how much income is taxed at each level before you get bumped up to the next tax rate) may increase with inflation, or not.

There are only two relatively safe assumptions that can be made from all these unknowns. Those who contribute at the top marginal tax rate are pretty certain to take money out at lower rates. Therefore they benefit from the rate change. Those who contribute at the bottom tax bracket are pretty certain to take money out at higher rates. Therefore they lose from the rate change. This reality is what prompted the government to create the TFSA.

Government Benefits

Many government support programs are means-tested. Their level of benefit depends on your income. Reducing your income with an RRSP contribution may increase the Canada Child benefit or the GST Credit when you are young, or increase the Guaranteed Income Supplement and Old Age Security benefits when at retirement. Increasing your income with RRSP withdrawals may reduce OAS , GIS, or the Age Tax Credit. Your taxable income can also determine your costs for long term care or subsidized community housing. How you deal with this depends on how entitled you feel to the benefits.

A huge fuss is made about the clawback of Old Age Security benefits, by people in retirement – people who had no TFSA option when they were saving. There needs to be a reality check. The median 2014 employment income in Canada was about $32,800. The median income of retired people, including government transfers, was $28,500. Anyone earning more than $60,000+ (at which OAS only starts to be clawed back) is far above ‘normal’ and certainly not deserving of taxpayer support, especially when the workers footing the bill earn less than the people they are supporting. Consider how you feel about people who refuse to get a job because the paycheque earned will be offset by a reduction in welfare benefits. Do you think these people are doing ‘good financial planning’? Or do you think they are abusing the system? Do you see the analogy?

Do you feel blessed to not qualify for benefits because you are wealthy? If so, just ignore the loss of benefits.

For young people it is different. they have a choice to save in a TFSA instead of an RRSP. Two people in the same ‘blessed’ situation will now face very different outcomes because of their choice of account for savings. Ignoring the impact on government benefits is not logical in the choice between account-types for new savings. But it is not the clawback of OAS that matters to the vast majority of us. It is the clawback of the GIS. While the RRSP withdrawal creates $1 claw-back for every $2 withdrawn, cash from a TFSA creates none.

The diagram above shows the tax bracket $ levels and tax % rates in the left column. The middle column shows the typical income in retirement. GIS is not taxed so it starts below the bottom of the lowest tax bracket. OAS is taxed, but not counted as income that causes a clawback of GIS. CPP is roughly 20% of someone’s ending wage (the average $8,221 benefit is assumed here). RRSP draws would fall in the box of Other Taxable Income. The following presumes there is no personal taxable income other than RRIF draws.

The median income earned by working Canadians is roughly at the top of the first tax bracket, so there is no way for them to withdraw RRSP funds in retirement without paying a higher tax rate when GIS clawbacks are considered. The claim that you will withdraw at lower rates is false. The promotional and educational RRSP material that fails to even mention a higher withdrawal tax rate and its resulting Penalty is unethical. The first $10,000 RRSP draw would clawback GIS at a bit more than 50 cents on the dollar, so its marginal tax rate would be the sum of the statutory 22.5% plus the 50% clawback = total of 72.5%. The average RRSP draw by seniors in 2014 was $9,700. So almost half of seniors withdrawing from RRSPs face this 72.5% tax rate.

The 72.5% rate gets reduced by larger RRSP draws as the GIS clawback is diluted. But still, assume you can save up $364,000 by retirement (in today’s dollars). That would require a $20,000 draw at the regulatory 5.5% rate. There are lots of high wage earners who fail to save $364,000. What tax $ would be paid on the RRSP draw? At the statutory 22.5% rate = $4,500. Add the GIS clawback still outstanding 10,400 – (8,200/2) = $6,300. The total tax (4,500 + 6,300 = $10,800) would be 54% of the $20,000 draw.

For those who contributed at the bottom bracket this will result in a material 31.5% Penalty (54% – 22.5%). That 54% rate is higher than all the tax brackets. Every saver, in any tax bracket, would face a penalty in this outcome. Because home prices have doubled or tripled, repaying those mortgages will soak up huge amounts of savings, resulting in smaller RRSP accounts and higher probabilities of this very situation.

The take-away here is ….. for those expecting a small RRSP account balance at retirement (and small draws), and who will not have other taxed income to trigger the GIS clawback, depleting the account early into a TFSA instead is critical – especially for those contributing at the bottom tax bracket.

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Notice in the diagram above how the clawback of OAS only increases your marginal tax rate by an additional 9% or 10%. You may have expected 15%, because 15 cents of OAS is clawed back for every dollar of income. But the OAS was originally taxed, so not getting the benefit means not paying tax on that benefit. The clawback increases your marginal rate by the after-tax benefit lost. So while in the 2nd tax bracket the net tax effect = 15% * ( 1 – 30.8%) = 10.38%.

The Canada Child Benefit starting in 2016 is income dependent and may have an impact on the RRSP/TFSA choice for workers with children at the top end of the bottom tax bracket. The increase in benefits from a reduction in income for one child is a marginal 7%, but for three kids it grows to 19%. Add this to the 22.5% statutory rate for an effective RRSP contribution rate of 29.5% or 41.5%. Use the government’s calculator to see the impact of an RRSP contribution’s reduction in taxable income. This increase in the marginal rate of RRSP contributions will not beat the opposite effect of a 50% clawback of GIS for those at the bottom of the first tax bracket, or those with limited life-long savings, but at the margins of the 1st and 2nd tax bracket, the additional 7% to 19% will tilt the choice toward using an RRSP.

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There is no economic justification for the different outcomes, RRSP vs. TFSA. Given a choice the government should prefer people use an RRSP because it provides governments with cash at the time they need it. The obvious solution to this inequity is to re-write the income qualification rules for benefits. The income measure used to qualify for GIS could include a deemed income from any TFSA balance. Multiply the RRIF’s Minimum Required Withdrawal % by any existing TFSA balance, and add this to the taxpayer’s other actual income.

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, it seems intuitively better to delay the claim when you predict your marginal rate will rise in a few years. After all, a $400 refund (40% tax credit on $1,000 contribution) is better than a $300 refund (at 30%).

But the real question is “If you predict a higher tax bracket soon, should you make the contribution in the first place?” The first step in answering that question is to measure and understand the cost of any delay in claiming the deduction. It is common sense that the sooner you collect what is owned to you, the better.

To understand the cost of delay in claiming the contribution’s tax deduction, revisit the analysis above where the RRSP was conceptually split into two – the TFSA part and the Difference part. It is repeated in the (A) chart. Compare that to the (B) chart with a one year delay in claiming the contribution credit.

(A)

(B)

The Difference column in (B) grows for only 9 years instead of 10. Instead of growing to $3,891, it only reaches $3,537. It is missing $354. This equals one year’s 10% profits on $3,537. This smaller balance is not sufficient to fund the withdrawal tax. The shortfall comes out of the saver’s pocket (although the resulting $248 penalty is 30% smaller than the $354 missing profits because the government eats its 30% share). The longer the delay, and the larger the rate of return realized by the investments, the more profits are missing and the greater the penalty.

So what do you do when you expect your marginal tax bracket to rise in the future? The decision to contribute to an RRSP, but delay claiming the tax deduction, should consider all the alternatives. It will rarely be the optimal choice. The optimal choice will always be to stash the funds in a TFSA for the interim. But maybe you have no TFSA contribution room. Your other choices are between using a Taxable account for the interim, or using the RRSP while claiming the deduction right away. This decision is modeled on the next webpage for RRSP Decisions.

Spend the refund if you like.

It is common to hear … “The tax refund from an RRSP contribution should not be spent. It should be either added to savings in the RRSP or TFSA, or used to repay debt, or put to some other good use”. This false belief starts from the right place, but ends up in a wrong conclusion.

It makes no difference how you spend any refund resulting from an RRSP contribution … as long as you do not increase your spending as a result of it. The word ‘increase’ is important. When the comparison of accounts was first presented (above) the presumptions listed for an apples-to-apples comparison included … “(ii) when wages and living expenses are held constant between options, any option that reduces taxes should result in larger savings”. But that does not mean that any RRSP refund must be the source of that additional savings.

Eg.
You have $5,000 extra cash in your chequing account.
Your marginal tax rate is 30%.
You expect any tax refund in 3 months.
In 3 months you will spend $1,500 on a vacation (or to reduce your mortgage, add to TFSA or RRSP, or whatever).

Question – how much would you contribute to an RRSP vs a TFSA?
1) You would put $3,500 into a TFSA and keep the remaining $1,500 to pay for the vacation. Or …
2) You would put $5,000 into an RRSP and use the tax refund to pay for the vacation.
Because you would take the vacation anyway, you have not increased your spending just because you pay for it with the RRSP refund. The values in the two accounts are equal because the larger RRSP balance allows for its withdrawal taxes.

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There is a second point to be made with this example. The $5,000 funding the RRSP comes from your chequing account – which by definition holds after-tax savings. But once inside the RRSP it becomes before-tax savings – because tax must be paid before it can be touched – because you get a $1,500 tax reduction no matter how realized. Where the actual dollar bills come from to fund an RRSP or TFSA makes no difference. Dollar bills are fungible. They do not carry with them labels like ‘after-tax’ or ‘before-tax’.

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There is a third point. In the example you may have spotted a slight timing difference. The TFSA could have been invested for 3 additional months (vs the RRSP) because of the delay in recovering the RRSP’s Contribution Credit.

Common sense says it is better to collect $$ owed to you sooner rather than later. How, and how fast you collect the value of the Contribution Credit is your personal decision, not an attribute of the system itself. If you delay collection then you will pay a penalty for that delay. See Delay Claiming the Deduction above. Choose the most speedy collection.

You can tell your employer to reduce the taxes withheld from your paycheques during the year – allowing you to save with before-tax dollars. Or, your employer may directly fund a company RRSP and not deduct taxes – making its contributions before-tax dollars. Or, you can borrow from your emergency fund for a top up equal to an expected tax refund.

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And a final point. Many detractors who dismiss the model presented above, do so on the grounds that …”It wrongly presumes that the refund is deposited in the RRSP.” Hopefully the arguments made above show that this model makes no presumption about the use of any refund. It does not even presume a refund is received. It DOES presume there is a contribution credit created by all contributions. This is always a true fact. How, when, and in what form, you collect that contribution credit is your business and makes no difference to the model, or how the RRSP benefits are created.

When modeling an RRSP contribution, it is wrong to presume the contribution credit is realized outside the RRSP. E.g. The true comparison to a $3,500 contribution to a TFSA is not $3,500 into an RRSP plus $1,050 (= $3,500 * 30% tax rate) outside. It was your choice to delay recovering the contribution credit. The true comparison is $5,000 into an RRSP … that was partially funded by $1,500 contribution credit recovered on time (= $5,000 * 30%).

Are the Tax Benefits of Investment Losses Lost ?

It is common to hear that the tax-recovery benefit of investment losses is lost when the loss is inside an RRSP. There is some truth to that, but not a lot.

First off, no one invests with the intention of losing money in the long run. And in the long run markets go up, so most everyone earns some kind of profit. In a taxable account both profits and losses generate tax effects, but over time you only pay tax on the net profits – profits minus losses. Neither the TFSA nor the RRSP is taxed, so their benefit equals their shelter from that same net tax. Losses have the same effect on profits taxed and profits sheltered.

But some loss of tax benefits may happen when market returns swing wildly from large losses to large gains (or vice versa). This is because tax effectively dampens returns. It reduces both after-tax profits and after-tax losses. Volatility reduces long-term returns. The box below shows the math. One year of 100% profits and the other year of 50% losses for a 0% cumulative return. It shows both the TFSA and RRSP ending up smaller than the taxable account. The taxes paid on profits reduce the principal exposed to the following year’s losses. The recovery of taxes on losses increases the principal exposed to the following year’s profits.

But there are huge qualifications to this idea that investment losses have more value in a taxable account.

• First – if the profit were 50% and the loss 25% the tax shelters would have beaten the taxable account – still a volatile return but with a net profit over the period. The volatility must be very, very extreme.

• Second – the math depends on the taxes being paid from the investment account. But are they? In real life taxes are paid from your chequing account. A smaller chequing account may result in your spending less, without any effect on additional savings. Maybe the differential savings go into the RRSP and not the taxable account. A reduction in a chequing account may impact your decision to add additional savings to the investment account, but it will not impact the existing value at risk in the investment account.There are a lot of maybe’s.

• Third – the math depends on the taxes being paid each year as profits are earned or lost. But they aren’t. In real life an investment may be held for many years as its price increases. By the time the market tanks, that loss may retrace only part of the gains, leaving the stock price still higher than at purchase. There will be no tax loss.

• Fourth – even if a loss takes the stock price below where it was purchased, claiming a capital loss in Canada will not generate at tax refund unless you have paid taxes on capital gains during the prior three years. Buy-and-hold investors who rarely trade may be out of luck.

• Fifth – the math shown is reasonable for a single security. But a portfolio of assets will have some losses offset by some gains. Taxes paid are paid on the net gains of all the assets. Portfolios are are lot less volatile than individual stocks.

The appropriate conclusion should be to not worry about any lost benefits in an RRSP from capital losses. It is a theoretical idea unlikely to exist in reality.

What tax rates do you use in the analysis ?

The tax rate for contribution and withdrawal, used as variables in the Deconstruct Benefits spreadsheet is not the marginal rate of the next dollar of income. Rather, it is the rate applied to the total RRSP contribution or withdrawal. First calculate your tax bill without any contribution or withdrawal. Then calculate it again with the contribution/draw. Subtract for the difference. Divide the $tax difference into the $contribution/withdrawal to get the marginal tax %rate.

(Difference in Tax $$ Paid)  /  (Contribution or Withdrawal $$)

The lower (higher) taxable income resulting from RRSP contributions (withdrawals) may change your qualification for other government programs, like GST rebates, OAS and GIS. The difference in expected $benefits should be included in the numerator of the calculation above. Some on-line tax calculators already include the OAS difference.

When using the In Or Out spreadsheet for practical RRSP decisions, the tax rate on withdrawal should be the incremental tax rate on withdrawal resulting from only the additional amount being considered for contribution. For example, a young person in the bottom tax bracket would expect to also withdraw those savings in retirement also in the bottom tax bracket, assuming government benefits use up the 0% tax bracket. But after 10 years of contributions and great rates of return, the account will have grown in size, The Minimum Required Withdrawals of the existing account are now expected to use up all the bottom tax bracket. Any additional contributions will be incrementally taxed at the second tax bracket on withdrawal. It is the second tax bracket’s rate that should now be used for the decision to make an additional contribution.

Remember also that RRSP withdrawals qualify as ‘pension income’ that can be split between couples in whatever proportion they choose. This may lower the effective withdrawal rate. Spousal RRSPs also allow for anticipated withdrawals at lower tax brackets than faced by the contributor.

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The tax rate on investment profits is a bit complicated. The statutory marginal tax rate for the type of income at your marginal tax bracket is just the starting point. You can look that up on the Tax Rate spreadsheet. Most people’s portfolios generate interest, dividends and capital gains income in different proportions. Use the ‘Weighted Average Tax Rate’ tab on the same spreadsheet to find the portfolio’s average rate.

Capital gains may be realized each year, or delayed decades. If you turn over your holdings yearly, the rate needs no adjustment. But if you hold stocks for (say) 10 years, the effective yearly rate is lower. Use the ‘Effective Capital Gains Rate’ tab to find a ‘good enough’ calculation. This is the rate for capital gains to use on the ‘Weighted Average Tax Rate’ tab.

The In Or Out spreadsheet includes two variables for the tax rate on investment income – for the periods (i) before retirement (while you are working) and (ii) after. While you are working, investment income earned outside an RRSP would be taxed at increasingly higher marginal rates as your salary rises (hopefully), and also the size of a taxable portfolio increases. By the time you retire both can be very high. There is no one correct variable input because it will be changing. See the effects of different inputs. After retirement, depending on the size of your CPP and other pensions, your effective tax rate will change. Remember that profits from investments held in Taxable accounts will trigger clawback of GIS, just like RRIF draws, resulting in the same huge effective tax rates.

RRSP Decisions and Choices

After the list of decisions grew too long, it was given a page of its own at RRSP Decisions.