RRSP Buyer's Regret

April 25, 2019 | Richard So


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Are you singing the RRSP Blues?

With April in full swing, Canadians have been rummaging through T-slips and statements in preparation for the month-end tax return deadline. At this time of year, we tend to hear one common tax complaint, which goes something like this: “I had to pay so much tax on the money I spent from my RRSP/RRIF. Why the heck did I put money into an RRSP anyways?!”

There seems to be a lot of anti-RRSP sentiment going around, with many regretting investing in their RRSP for so many years. It seems painful and disadvantageous to be taxed fully on the amounts withdrawn from one’s retirement savings account. This has even led some to caution their younger family members to steer clear from RRSPs, labelling them as a future “tax trap.”

In our view, most Canadians do benefit from contributing to RRSPs. The main reasons to invest in an RRSP are:

1. Tax deduction today – While in your employment years, receiving a tax deduction is valuable, as it means paying less tax today. For most Canadians, receiving this immediate and tangible benefit is impactful.

2. Tax-deferred compounding growth – The power of compounding growth of savings is supercharged, when done on a tax-deferred basis.

3. Lower tax bracket in the future – Most Canadians are in a lower tax bracket in retirement, relative to their working years. Spending your RRSPs in retirement should attract less tax.

Should I withdraw my RRSP early to reduce my estate tax?

Many investors bemoan the tax rule that states that when an account holder passes away (with no spouse), the full RRSP amount is taxed fully in that given year. Those investors with sizeable RRSPs realize that their beneficiaries will take at least a 50% haircut on their inheritance. To try to minimize this one-time tax hit, they perceive it as advantageous to withdraw their RRSPs faster in their lifetimes. Unfortunately, this may not be the best strategy, as it essentially means that one would be pre-paying tax earlier than needed. The principal of “Time Value of Money” tells us that the value of a dollar today is worth less than a dollar in the future. Hence, it is mathematically beneficial to defer paying a tax liability into the future. Furthermore, drawing large amounts from your RRSP and moving it to a non-registered account simply leaves you with less money to invest. For example, withdrawing $50,000 from your RRSP results in having only $25,000 to invest, due to an approximate 50% tax rate. Finally, drawing funds from your RRSP puts you at risk of being bumped up to a higher tax bracket today, and perhaps even worse, could disqualify you from certain government pension benefits, such as Old Age Security (OAS). Before one decides to aggressively draw down their RRSP, it is wise to consult an accountant, who should take into consideration your existing income, future tax brackets and the size of your RRSP. It may be the case that paying the RRSP tax through your estate is ultimately the smaller tax bill, relative to drawing it earlier.

Should I contribute to an RRSP, or pay down my mortgage?

With discipline and budgeting, Canadians should be able to do both. When contributing to an RRSP, you will receive a tax deduction, which, for most tax-filers, will lead to a tax refund in the mail. Instead of seeing this refund as a “windfall” to be casually spent, we would recommend putting the refund towards paying down your mortgage. In this situation, the government is essentially helping you pay down your mortgage faster!

Should I contribute to a TFSA instead of an RRSP?

Most investors are attracted to the fact that withdrawals from your TFSA are not taxed as income. That said, contributions into your TFSA come from “after-tax dollars,” which makes it a more “expensive” contribution. Assuming a 50% income tax rate, one must earn $12,000 of income in order to net out $6,000 to contribute into your TFSA. RRSPs provide a full tax deduction so a $6,000 contribution costs exactly $6,000. Similar to the above scenario, the ideal situation is that one contributes into their RRSP first and takes their tax refund to contribute into the TFSA. This way, you can have your cake and eat it too!