Given that we are approaching the end of RRSP season, I thought it would be fun to dispel the most common RRSP myth that I see repeated over and over again in the media.
Since the invention of the TFSA, there have been many articles written comparing RRSPs and TFSAs. One typical line of advice about RRSPs is that the RRSP is only advantageous if your marginal tax rate in retirement is lower than your marginal tax rate when contributing. If the marginal tax rate is the same in retirement as when you are making contributions, then there is no tax saved.
Marginal tax rate is the tax rate charged on the last dollar earned in a year.
This rule is simple, easy to understand, but it’s just not usually true.
Note that this article really only applies to middle class earners. If you are in a low income tax bracket, then RRSPs are probably not beneficial and can even be harmful financially compared to alternatives. If you are going to be getting a very good pension in retirement, then RRSPs have little benefit as well.
This rules seems to assume that taxes on withdrawals are paid at your marginal rate which is not the case.
When you make a contribution to an RRSP – the tax deferred from RRSP contributions is calculated at your marginal tax rate (or close to it, if your RRSP contributions span more than one tax bracket).
When you withdraw money from your RRSP or RRIF – the tax is calculated using your average tax rate (after other income sources such as pensions).
This is a bit complicated, so let’s look at this concept in chunks:
RRSP contributions are made at marginal (or close to marginal) rates
If Sue from Ontario makes $100,000 per year and contributes $10,000 to an RRSP, she is able defer taxes of $4,314 (43.14% of $10,000) that would have been owed on her last $10,000 of income.
RRSP or RRIF withdrawals are made at the average tax rate
When you earn income, there are different tax bracket rates that apply to different parts of your income. Taxtips.ca has all these tax brackets if you are interested. For example, Sue earns $100,000 per year and her marginal tax rate is 43%. But she doesn’t pay $43,000 of income tax each year. In fact, she will only pay about $30,000 in taxes for an average tax rate of 30%. This is because the tax rates for lower income levels is less than her 43% tax rate on her highest income.
Let’s look at a very simple example where Sue works for 10 years, contributes $10,000 per year to her RRSP (with no taxes being deducted at the source) and then decides to take a year long sabbatical and withdraws all the money from her RRSP in her sabbatical year. If her savings earns 3% per year, she will have $102,000 in her RRSP to use during her sabbatical.
The amount of tax she will pay on $102,000 of income (we’re going to pretend that there are no changes in tax rates in the 10 years) will be $27,647.
Has she saved any taxes? Yes – she would have paid $4,314 in taxes for each $10,000 that she saved over the ten years for a total tax bill of $43,140. In the end she will have saved $15,493 in taxes by using her RRSP as savings account even though the marginal tax rate on the withdrawal is the same as marginal tax rate when she made her contributions.
Ok, that example was pretty simple and leaves out an important fact for someone in retirement – they are very likely to have some sort of base pension income such as OAS and CPP and possibly other pensions as well.
Let’s look at another example which is still pretty simple, but includes some other base income.
Joe earns $82,000 per year in Ontario which puts him at the 39.4% marginal tax rate. He contributes $12,000 per year for 40 years and earns 5% per year. When he hits retirement he has $1,453,000 in his RRSP and decides to withdraw $58,000 per year. Joe is already getting $6,000 per year for OAS and $12,000 from CPP and $12,000 from a trust fund for a total of $88,000 per year. So he’s making more money in retirement and his marginal tax rate is a bit higher than when he was working (43% vs 39%).
The amount of tax he will be paying on the RRSP withdrawal portion of his income each year will be $17,891 which is an average tax rate of 31%.
Joe has significant pension income, makes more money in retirement, his marginal tax rate is higher, but the average tax rate on his rrsp withdrawal is still less then the tax rate he saved at when making his contributions.
In both of these examples, the income in retirement (or sabbatical) is a bit higher than in the earning years. Even in this case, RRSPs will likely still save you some taxes or at worst – won’t save you any tax, but won’t cost you anything either.
Most people will earn significantly less in their retirement years and the tax differential will be much greater. A middle class earner who saves regularly and will make less money in retirement cannot lose by using RRSPs. They can even earn the same income in retirement or a bit more and still come out ahead with RRSPs.