Every winter, the media are chock full of RRSP stories. That’s great. Registered retirement savings plans can be a terrific wealth-building tool, so the more awareness, the better.
Unfortunately, not everything you may have heard about RRSPs is true. In fact, some of the most widely accepted notions about RRSPs are myths. These myths are repeated so often in the RRSP echo chamber – even by well-meaning financial “experts” – that few people question them.
Today, I’m going to refute what I consider to be three of the biggest RRSP myths.
Myth No. 1
The RRSP refund creates wealth
No it doesn’t. The refund is really just the present value of the tax you will eventually have to pay the government.
Example: Say you’re in a 40-per-cent tax bracket and you contribute $1,000 to an RRSP. You receive a $400 tax refund. Like magic, you now have $1,400, right? Wrong. You have $400 in after-tax funds outside your RRSP, plus $1,000 in pre-tax funds inside your RRSP.
If you were to withdraw the money from your RRSP you’d pay $400 in tax and keep $600 (assuming your marginal rate remains at 40 per cent). Add that $600 to the $400 refund and you’re back to where you started – with $1,000. The tax refund does not make you any richer.
True, you’ll benefit if your marginal tax rate is lower when you withdraw the money (this is a big benefit of RRSPs). On the other hand, you could be in a higher tax bracket, particularly when you consider clawbacks on income-tested government benefits and credits.
And here’s a key point about that $400 tax liability: It grows along with your RRSP. If your RRSP doubles, your tax bill will also double (again, assuming no change to your marginal tax rate). If your RRSP quintuples, so will the tax.
Myth No. 2
All of your RRSP investment earnings are taxed
Returning to the example, say the $1,000 in your RRSP grows to $5,000 through a combination of dividends and capital gains. When you withdraw the money, you’ll pay $2,000 in tax (40 per cent of $5,000) and keep $3,000.
Some people look at that and think: “Paying 40-per-cent tax is a rip-off. If I keep my stocks outside my RRSP instead, I’ll pay far less tax because of the dividend tax credit and the 50-per-cent reduction on capital gains taxes.”
Wrong again. This is a huge misconception that arises because people confuse pretax with after-tax dollars. The initial $1,000 inside the RRSP is pretax. At a 40-per-cent marginal rate, it’s actually equivalent to $600 after tax outside the RRSP.
If you had invested $600 outside the RRSP and earned the same rate of return, would you have ended up with $3,000? No. You would have ended up with much less than $3,000. Why? Because outside the RRSP, your dividends and capital gain are both taxed. The fact that they are taxed at a lower rate than 40 per cent is a red herring; what matters is that they are taxed at all.
Inside an RRSP, on the other hand, your money – that is, the capital minus the government’s share – grows tax free. In the example, you end up with $3,000 – exactly five times your initial after-tax investment of $600 (The $1,000 contribution minus the $400 tax refund). The government’s share also quintuples, to $2,000 from $400.
The notion that you pay more tax on investment earnings with an RRSP is an illusion. If you assume a constant marginal tax rate and adjust for pretax and after-tax amounts, investments inside an RRSP will always outperform identical investments held outside an RRSP. (The same is true for tax-free savings accounts.)
If you have a lower marginal tax rate in retirement, the benefit is even greater. However, even if you have a slightly higher tax rate in retirement, you could still come out ahead thanks to the tax-free compounding inside the RRSP.
Myth No. 3
You should always keep fixed-income inside your RRSP
This may have been true when interest rates were higher. But with rates near historic lows, the argument is not nearly as compelling.
Those who advocate this strategy argue that, because fixed-income is taxed at an investor’s marginal rate outside an RRSP, while dividends and capital gains receive preferential tax treatment, it follows that fixed-income should therefore go inside the RRSP, and stocks should remain outside (assuming the person doesn’t have room for both inside the RRSP).
The problem with this argument is that it ignores the rate of return. True, interest is taxed more heavily than dividends or capital gains, but if a guaranteed investment certificate is yielding just 1 or 2 per cent, and a stock has an expected return of, say, 10 per cent, then the stock could very well generate a higher tax bill outside the RRSP than the GIC would.
Hence, an investor who has limited RRSP room would achieve greater tax savings by putting the stock inside the RRSP and leaving the GIC outside.
I’m not saying this is always the best strategy – it depends on a person’s marginal tax rate and other factors.
This is complex topic that I’ll explore in greater detail in an upcoming column.