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investor clinic

After my column two weeks ago about registered retirement savings plans, I heard from a few readers who slammed RRSPs as a financial trap.

"My biggest mistake was opening up an RRSP and my second biggest was putting money into it for as long as I did," one reader wrote.

People criticize RRSPs for various reasons. Some are valid. Some aren't.

For example, it's true that RRSPs are often a bad idea for those in the lowest income bracket. That's because every dollar withdrawn results in a 50-cent reduction in the guaranteed income supplement (GIS). Combined with income taxes, which many GIS recipients pay, the "effective marginal tax rate" (EMTR) on RRSP withdrawals for low-income seniors can be 75 per cent or higher, according to a 2003 C.D. Howe Institute paper by Richard Shillington.

It's also true that students, many of whom don't earn enough income to pay tax, should consider avoiding RRSPs or carrying forward the tax deduction to a future year when their marginal tax rate is higher. Otherwise, they will be wasting the tax deduction and needlessly subjecting the funds to tax upon withdrawal, said Camillo Lento, assistant professor of accounting at Lakehead University.

"Most students would be better off using a tax-free savings account instead," he said. "The TFSA gives you the flexibility to pull that money out tax-free for whatever you want, whenever you want, and then recontribute it."

Some other arguments against RRSPs don't stand up to scrutiny, however.

I've heard from retirees who resent having to make government-mandated withdrawals from their RRSPs and pay tax on the funds. Some have found that, instead of being in a lower tax bracket in retirement, they're in the same or slightly higher bracket. Others have told me that RRSPs are harmful because all withdrawals are taxed at their marginal rate, whereas dividends and capital gains outside an RRSP receive preferential tax treatment. These people believe they would have been better off skipping RRSPs altogether.

I think they're wrong, and today (and next week) I am going to show you why. The truth is that RRSPs are beneficial, not only for people whose tax rates are the same or lower in retirement, but even for some (but not all) people who find themselves in a higher tax bracket when they make withdrawals.

One reason people bash RRSPs is that they don't understand the difference between pre-tax and after-tax dollars. They think that $1,000 inside an RRSP is worth the same as $1,000 outside. It's not. The $1,000 inside the RRSP is pre-tax. The $1,000 outside the RRSP is after-tax. At a marginal tax rate of 30 per cent, $1,000 pre-tax inside an RRSP is actually worth just $700 on an after-tax basis. At a marginal rate of 40 per cent, it's worth $600. And so on.

So when people complain about paying a lot of tax on RRSP withdrawals, they're forgetting that not all of the money inside the RRSP actually belonged to them in the first place. A portion of it is tax that they have yet to pay. The amount of implied tax owing starts out small, but as the RRSP grows over many years or decades, so does the amount of tax that eventually has to be paid.

I provided an illustration of this in a previous column. Assuming a constant marginal tax rate, when a person makes an RRSP withdrawal the money they pay the government is nothing more than the initial tax that was deferred plus the growth of that tax. The portion of their RRSP that actually belongs to them – net of the implied tax owing – grows completely tax-free.

That's why, if you start with amounts that are equivalent on an after-tax basis, an investment inside an RRSP will always beat the same investment held in a non-registered account, again assuming no change in the tax rate. The notion that dividends and capital gains are taxed more heavily with RRSPs is an illusion.

RRSPs are even more advantageous if your tax rate drops in retirement, because you forgo tax at a higher rate (on contributions) and pay tax at a lower rate (on withdrawals).

Next week, I'll look at how even individuals with a higher marginal effective tax rate in retirement can benefit from RRSPs.

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