Monday, 11 July 2016

RRSP Bashing

I am sure at any BBQ, any brunch, heck even a good old poker game with the guys can generate conversations regarding money.  One particular topic that I have engaged in a few times this year already are anti-RRSP or RRSP bashers.  Yes, you are correct, there are more than I care to share, numbers of people who do not and will not ever, open an RRSP account.  They say they have to pay all that tax back.  They'd rather just spend that money now and have absolutely not a penny in savings except what they have in their savings or checking account.  I ask them what happens when you get to around 58 or 59 years old, and your salary is at $80,000 a year, what happens when you stop working for medical or some other reason.  Where is that $80,000 or even $50,000 a year going to come from for the next 10 years?  They say, it will work itself out.  Seniors living in poverty is not an idea I enjoy. Neither does the government, that is why they have given us RRSPs.

Anti-RRSP individuals will complain about how you can't use the lucrative dividend tax credit or how contributing to an RRSP would turn a tax free windfall into taxable income when taken out of the RRSP.  Also mentioned is how the 50% reduction in capital gains tax is lost.

This type of ideology stays alive, they can only think of the tax they have to pay rather than take the time to understand how RRSPs work.

So here will be a basic, simple example of how RRSPs work, this could be the last time but I doubt that, as RRSP bashers will always be out there.

Let's look at a simple example.

Assume an individual has saved $10,000 for the year and she's wondering whether she should invest it inside an RRSP or in a non-registered account, or worse, just spend it on something like the mortgage (this could lead to the house poor post I've done before).  We will assume her marginal tax rate is 40% and regardless of which account she chooses to invest in, that that stock triples in 20 years.

Would she be better off in a registered or non-registered account?

Before we get an answer to this question, the tax refund needs to be looked at.  Assume her employer deducts taxes from her pay cheque.  If she contributes $10,000 to her RRSP, she will receive a $4,000 tax refund, so that $10,000 RRSP contribution wouldn't actually cost her $10,000, it would cost her just $6,000 ($10,000 minus the $4,000 refund).

Stated another way, if her marginal tax rate was 40% then $10,000 inside an RRSP (which is pretax dollars) is equal to $6,000 in a non-registered account (which contain after tax dollars)

Now we can use these numbers to do a fair comparison.

First, investing inside the RRSP, the $10,000 would grow 3 times in 20 years to $30,000.  If she sells the stock and withdraws the money, she will pay $12,000 of income tax (40% of $30,000) and be left with $18,000 net.

Now, investing outside the RRSP, the $6,000 would grow 3 times in 20 years to $18,000.  If she sells the stock and withdraws the money, she will pay capital gains tax of 20% (half of 40%) on the $12,000 which is the difference between her purchase price ($6,000) and sell price ($18,000).  After deducting $2,400 in income tax, she is left with $15,600 net.

Winner winner chicken dinner.  RRSPs win.  The return in the RRSP setup is better.  Notice that the difference between the RRSP and the non-registered totals ($18,000 versus $15,600) is equal to the capital gains tax ($2,400).  Far from losing the 50% capital gains reduction, the RRSP avoids capital gains entirely.

With an RRSP, the only tax is on withdrawals.  Bashers love to complain about the tax on withdrawals because it looks so large, but really its just the original tax they deferred plus growth of that tax over time.  As the example above shows, even after pay tax on withdrawals, the RRSP investor still wins.  If an investor's marginal tax rate is lower in retirement, the benefits of the RRSP are ever greater, go ahead, try the withdraws at 30%, and watch how much tax you all be saving on withdrawing $50,000 or $60,000 a year.

You will soon see that the RRSP Bashers are really bashing their own head with the money they are losing in tax savings.