“Is it better to just invest and pay your taxes now or is it better to invest through RRSPs? Or are they about the same return?”
This question came from a reader, Dan, who I met when I spoke to the Ottawa Share Club.
Most people focus on the immediate tax refund from making RRSP contributions, but this is really just a tax deferral. You will have to pay these taxes when you eventually withdraw the money. If your tax rate is lower when you withdraw the money, you end up saving on taxes, but this is not the primary advantage of RRSPs.
By deferring taxes you get the benefit of having the returns on your savings compound tax-free. If you invest in a regular taxable account and pay the taxes owing each year, you lose out on much of the compounding. An example will illustrate this nicely.
Rhonda is 25 years old. She plans to open an RRSP and contribute $10,000 this year and increase this amount by inflation each year for a total 40 years. This year she’ll get a $4000 tax refund making the net cost to her this year $6000.
Thomas is also 25 years old. He plans to open a taxable investment account and deposit $6000 this year and increase this amount by inflation each year for a total of 40 years. Thomas plans to pay any investment taxes owing out of his savings each year so that his net cost will be the same as Rhonda’s net cost.
Both investors will retire at age 65 and withdraw a fixed after-tax amount each year (rising with inflation) that will exhaust their savings after 25 years.
The question is: who will get the larger retirement income? To answer this, we’ll have to make a series of assumptions.
Taxes: To isolate the benefits of compounding in RRSPs, we will assume that both investors have constant tax rates throughout their lives: 40% on regular income, 20% on capital gains, and 13% on dividends.
Returns: Both investors have a mix of stocks and bonds that earn 7% per year (4% capital gains, 2% dividends, and 1% interest).
Turnover: Both investors change 20% of their investments each year. This doesn’t affect Rhonda much, but it causes Thomas to pay some capital gains taxes each year.
The costs to both investors are the same, and if both approaches were equally good, then we would expect both Rhonda and Thomas to have the same income in retirement. But that’s not how it works out. After fighting with Excel for a while, here are the results:
Yearly after-tax income in retirement in today’s dollars:
This is a big difference that we can attribute to the power of tax-free compounding. Any advantage due to having a lower tax rate in retirement would be extra.
The main message is that if you have a long investing horizon, RRSPs can give a big advantage. Tax-Free Savings Accounts (TFSAs) have this advantage as well.