After the weather, the thing Canadians love to complain about the most is the tax they pay on RRSP withdrawals.

Well, time to stop grumbling. It may seem like you're getting hosed on your registered retirement savings plan withdrawals, but you're just paying the government the tax you initially deferred, plus the growth of that tax.

Many investors don't get this.

"There's a big misunderstanding that the money in an RRSP is actually your money. It's really a partnership between your money and the government's money," says Jamie Golombek, managing director of tax and estate planning at CIBC Wealth Advisory Services. "If people have $100,000 in an RRSP, they don't really have $100,000."

Here's something else a lot of people don't get: Even after paying the government its share, most people will be far better off than if they had invested in a non-registered account.

Let's look at a few examples taken from Mr. Golombek's paper, Just Do It: The Case for Tax-free Investing.

First, consider an investor who contributes $3,000 to an RRSP and has a constant marginal effective tax rate (METR) of 33.33 per cent. (The METR takes into account income tax and the loss of income-tested benefits including Old Age Security and the age credit.)

It would actually cost the investor just $2,000 of after-tax funds to do this. How? He could take $2,000 of his own money, borrow $1,000 to make the $3,000 RRSP contribution, and then use the $1,000 tax refund to pay back the short-term loan (with negligible interest).

Another way to look at this is to imagine that $3,000 of employment income, before any tax is deducted at source, is deposited directly into the RRSP. In this case there would be no tax refund, because no income tax was paid.

Either way, the critical point here is that, at a marginal tax rate of 33.33 per cent, $2,000 in after-tax funds (outside the RRSP) is equivalent to $3,000 in pretax money (inside the RRSP).

Assuming the investor earns a return of 5 per cent in his RRSP, after one year he would have $3,150 in pretax dollars. If he withdraws all of the funds, he would pay tax of 33.33 per cent ($1,050) and be left with $2,100.

This represents an after-tax return of 5 per cent on his initial $2,000 investment. The example illustrates that, if the METR does not change, the investment grows tax-free inside an RRSP (just as it does with a tax-free savings account).

Now consider what would have happened if he'd invested in a non-registered account instead. The $2,000 after-tax outside the RRSP (equivalent to $3,000 pretax inside the RRSP) would have grown to $2,100 after one year. But because it's in a non-registered account, the investor would have had to pay tax on the $100 difference. The amount of tax would depend on whether it was interest, dividends or capital gains, but the key point is he would have to pay some tax (unless he had very little other income).

So the RRSP is clearly the better choice here.

What's more, the longer the time horizon, the bigger the advantage RRSPs have over non-registered accounts.

Mr. Golombek compared two long-term scenarios. In the first, he assumed the investor makes an RRSP contribution of $3,000, which grows at an annual rate of 5 per cent over 40 years, for an ending RRSP value of $21,120. After withdrawing the funds and paying tax of 33.33 per cent ($7,040), the investor would be left with $14,080.

In the second scenario, the investor puts $2,000 in a non-registered account at the same growth rate of 5 per cent, all of which is assumed to have come from capital gains (that is, there are no taxes on dividends or interest along the way). At the end of 40 years, the person would have $14,080 – the same as in the first scenario.

However, in the second scenario there would be capital gains tax of $2,013 (one half of the gain of $12,080, multiplied by 33.33 per cent), which results in an after-tax ending value of $12,067 – $2,013 less than in the first scenario.

"Clearly the RRSP beats the non-registered account when [the] METR stays the same upon ultimate withdrawal, due to the tax-free investment income earned in the RRSP," Mr. Golombek writes.

Obviously, the case for RRSPs is even stronger if the METR is lower in retirement, which is the case for many people.

But what if the METR is higher?

Mr. Golombek ran the numbers again assuming an individual's METR rose a full 10 percentage points, to 43.33 per cent in retirement from 33.33 per cent at the time of contribution.

Again assuming a 5 per cent return exclusively from capital gains, the RRSP would underperform over the first couple of decades on an after-tax basis, reflecting the higher METR on withdrawals. However, the RRSP would surpass the non-registered account after 23 years, because of the additional years of compounding.

At a higher rate of return, it would take even less time for the RRSP to outperform. With a return of 6 per cent, the RRSP would come out ahead after 20 years, at 7 per cent it would take 17 years, and at 8 per cent it would take 15 years. Most people invest for much longer in their RRSPs, of course.

The break-even period would actually come even sooner in real life, Mr. Golombek says. That's because many investors earn interest and dividend income, which is taxed every year in non-registered accounts, and not solely capital gains.

As I mentioned in my column last week, RRSPs aren't appropriate for everyone. But before you get too depressed about the amount of tax you pay on withdrawals, consider that you're very likely coming out ahead in the long run.

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