Is an RRSP bad tax planning?

Question – I may have a larger income when I retire then I do now. If this is the case, and tax brackets are similar to what they are now, I may be in a higher tax bracket. If so, then what is the advantage of investing money in an RRSP? Wouldn’t I be better off to pay the tax now and invest my money in non-sheltered mutual funds and securities? This way I would pay tax while I am in a lower bracket and I would have the flexibility to invest in mutual funds and other securities without being limited to 20% foreign content. – T.W.

Answer – As a point of fact before answering your question, the foreign content limit for registered plans is now 30%.

Now to your question, which raises an interesting point. You don’t tell us how old you are, but age has to be taken into account in your decision here. That’s because the money in an RRSP will compound tax-sheltered, and the longer the time remaining before retirement, the greater the importance of that. Also, you don’t provide your current tax bracket or the tax bracket you expect to be in at retirement.

So let’s construct a scenario. We’ll assume you are 50 years old d are currently paying tax at a marginal rate of 33%. We’ll say that when you retire at 65, you expect that rate to rise to 39%. It’s unlikely you would face a tax bracket jump that high, but we’ll use this as our hypothesis.

You have $5,000 a year to invest and you expect a return of 8% annually. Let’s look at what might happen.

By investing within an RRSP, you put the full $5,000 to work for you plus you generate a tax refund of $1,550. At the end of 15 years, your annual RRSP investment is worth $135,760 and change. If you pay tax at a marginal rate of 39% on the full amount as it comes out of the plan, the after-tax value is about $82,814. You’ve also accumulated $23,250 in refund payments, which you have either spent or invested. If you invested this money, you’d pay tax on the income. For someone in a 33% tax bracket, the effective tax rate on dividends is 17% and on capital gains it is 16.5%. Interest is taxed at the full rate. If we assume one-third of the income comes from each source, your tax rate on the investment income from the refunds will be around 22%. For ease of calculation, let’s assume that your after-tax return on your invested money is 6%. The end result is that you’d have about $36,100 in a tax-paid, non-registered portfolio. Total after tax assets would therefore be about $119,000..

Now let’s assume you don’t make the RRSP contribution but invest $5,000 a year in a non-registered portfolio. You earn an average of 8% annually there as well, which will be subject to tax. Again, we’ll assume a diversified portfolio, with an after-tax annual rate of return of 6%. At the end of 15 years, your portfolio will be worth $116,380.

As you can see, even with a marginal tax rate in retirement that is six percentage points higher than today, you still come out ahead with the RRSP as long as you reinvest the refund. If you spend the refund, then your non-registered portfolio approach ends up being worth more. But you have to weigh that against how you spent the money. If you used it to, for example, pay down a mortgage, then a whole new set of dynamics is introduced.

As you can see, it is not an easy question to answer. – G.P.