Dispelling Myths about RRSPs

Participation rates for the RRSP have been declining over recent years. In fact, some Canadians believe there is “no point” in investing in the RRSP because of the taxes due in retirement. But the RRSP can provide a substantial tax advantage. Let’s look at a couple of the myths:

Myth: There is no point in investing in an RRSP.  You pay all the savings back in taxes when you retire.

While you do pay tax on RRSP withdrawals, don’t forget that you received a tax deduction at contribution. This is often overlooked: people confuse pre-tax with after-tax dollars. A $4,000 RRSP contribution is equivalent to a $2,800 after-tax contribution to a non-registered account at a 30 percent marginal tax rate.

Myth: The RRSP is disadvantaged. Investment earnings are subject to higher taxes, since withdrawals incur tax at regular rates, whereas capital gains realized in a non-registered account are taxed at a lower rate.

If you assume a constant marginal tax rate and adjust for pre-tax and after-tax amounts, the RRSP will generally outperform a non-registered account that holds identical investments. The chart below demonstrates this outcome, whereby a pre-tax contribution of $4,000 has been made for 20 years. The example assumes a 30 percent marginal tax rate and growth of capital at 5 percent over a 20-year period.

1. Realized capital gain of $97,214 – $56,000 = $41,214 taxed at 50% inclusion rate.

The benefit is even greater if the individual has a lower marginal tax rate in retirement.

As such, don’t overlook the tax-deferral benefits of compounding over time using the RRSP.