Starting with the example of a 40% marginal tax rate, an investor can either save $6000 in a non-registered account or $10,000 in an RRSP (and get a $4000 tax refund for the same $6000 out of pocket amount). With an 8% return in the first year, the RRSP would grow to $10,800 and the non-registered account would grow to $6480.The short answer is that we haven’t accounted for the income taxes on the non-registered gains yet. Any interest would be taxed at 40%, capital gains at 20%, and dividends at around 19%. Even if the gains are all capital gains, the investor would have to pay taxes before he could spend the money.
However, if the investor withdraws the RRSP money and pays taxes on it, he will have $6480 left. This is the same amount as was in the non-registered account. How is the RRSP any better?
In just one year the advantage of the RRSP is modest, but it can be substantial over a lifetime. I put together a spreadsheet covering 35 years of contributions and 25 years of retirement for the RRSP and non-registered cases. The following assumptions are built into the calculations:
– 8% return each year (70% capital gains, 20% dividends, 10% interest)
– 4% inflation each year
– marginal tax rate 40% (This stays constant so that we can isolate the value of tax-free compounding from changes in tax rates.)
– 10% of equities turn over each year during the saving phase (no turnover during retirement)
– $6000 saved per year in non-registered account ($10,000 in RRSP) growing with inflation
– find the constant yearly withdrawal amount (in today’s dollars) that exhausts the money in 25 years
Final results of yearly (after tax) withdrawals in today’s dollars:
This is a substantial difference in yearly after-tax spending money. With these assumptions the RRSP is clearly the better choice. Under the assumption of a constant marginal tax rate, a TFSA works just as well as an RRSP.
There are circumstances where using an RRSP is not in an investor’s interests, but this is usually when the investor’s marginal tax rate is higher in retirement than it was while working. For most people it makes sense to use RRSPs and TFSAs.