Does it pay to invest in an RRSP? Here’s the math

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This is always an exciting time of the year for finance geeks like me or people who get excited over things such as updating spreadsheets. You see, I am a fan of registered retirement savings plans (RRSPs), tax-free savings accounts (TFSAs) and all other tax-deferred, tax-sheltered vehicles, because one of the sure things in financial planning is that taxes inevitably trend up over time.

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Even though we live in a country with relatively high personal income taxes, contributing to an RRSP can still be a contentious topic, and, from time to time, I’ve heard people question the merits of an RRSP. Here are a couple of their main objections:

Since not all gains in the investment portfolio are fully taxable, such as capital gains, is it wise to put money into an RRSP only to have all the withdrawals be fully taxed as regular income?

Upon withdrawal, seeing a part of the hard-earned retirement income reduced by a withholding tax can be heartbreaking.

But consider this:

RRSP contributions can significantly reduce your overall taxable income in the tax filing year and enhance your retirement savings;

Investment portfolios grow tax-free while invested within the RRSP, and the interest-compounding effect is magnified even more over longer-term time horizons;

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The difference between current and future income tax brackets matters. With proper planning, overall taxable income in retirement should be lower than your peak income years;

And, having a diversified set of income streams to draw on in retirement can maximize flexibility and tax efficiency.

Let’s look at a numeric example of investing in RRSPs versus a non-registered account. We will keep the assumptions simple. The investment has a six-per-cent annual return of interest income and you have a marginal tax rate of 40 per cent each year.

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Since contributions to your RRSP are effectively made with before-tax dollars and contributions to your non-registered account are made with after-tax dollars, we’ll also assume you have $10,000 to invest in your RRSP and $6,000 ($10,000 x 60 per cent) after-tax funds to invest within your non-registered account.

Finally, for a simplified, but complete net after-tax rate comparison, the example assumes you withdraw the entire amount from your RRSP and pay tax at your marginal tax rate of 40 per cent at the 10-, 20- and 30-year marks.

We have kept the assumptions conservative, but the accompanying table shows we were still able to demonstrate a net benefit of investing in an RRSP.

Convinced? Here are three helpful tips to help you make the most of your RRSPs.

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You can contribute as early as the first day of the year and claim your contribution when you are ready to file your taxes.

RRSP contributions are used to reduce your overall taxable income for the year. A shorthand for calculating your tax refunds is to multiply the contributed dollar amount with your marginal tax rate as an approximation.

You can borrow to contribute to your RRSP, but whether you should really depends on your income tax bracket and individual situation. Given the current low interest rates, there can be merits in borrowing to invest, but leverage should be used with caution and only after careful consideration of your financial situation and overall financial plan.

Happy saving and investing.

Rita Li is an investment adviser with RBC Dominion Securities, RBC Wealth Management.

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