Tuesday, February 8, 2011

Mental Blocks on RRSPs

Many commentators have made good analyses of the advantages and disadvantages of RRSPs (for example, see Canadian Capitalist's look at the PH&N report. However, many who rail against RRSPs make a fundamental mistake in their thinking.

For the purposes of this discussion, I’ll consider a Canadian Jerry who has a 40% marginal tax rate. If Jerry makes a $10,000 RRSP contribution, he will get a $4000 tax break. If he chooses to save outside an RRSP, he will have to pay the $4000 in taxes. This means that his choice is either to save $10,000 within his RRSP or $6000 outside his RRSP. Too many RRSP bashers lose sight of this fact.

One way to think of this is that 40% of the money in the RRSP is not really Jerry’s or is some sort of bonus. Unfortunately, we’re not really wired to think this way. If Jerry’s salary were doubled, he’d be shocked initially and would feel very lucky and somewhat undeserving. Over time, though, he’d come to think that this new salary is his due. He’d probably even come to think he deserved more. This is human nature.

If Jerry has money sitting in his RRSP for years, he will think of it as entirely his money. The past tax deductions will be forgotten over time. As he comes to the age where he starts living off his savings he will resent paying taxes on these withdrawals.

Suppose that by his retirement Jerry has $500,000 saved in his RRSP. Jerry might be starting to regret having made RRSP contributions. After all, if he had $500,000 outside his RRSP he’d pay much less income tax in the future. The problem with this thinking is that if he hadn’t made RRSP contributions, the most he could have saved is $300,000 and that’s only if he somehow managed to avoid paying any taxes on gains over the years. In reality, he’d have less than $300,000 saved.

There are people who are better off without making RRSP contributions, but these tend to be those with very low incomes or who are in special situations. Most people do benefit from using RRSPs.

10 comments:

  1. Mike
    I was going to post in my blog on this topic later today, so have a few thoughts to pass on (hence rather lengthy comment). No doubt it’s human nature not to want to pay taxes when the time comes to pay the piper! Been there, done that myself. I can also see, though, some objective reasons for the disenchantment, at least from feedback I’m getting from readers. One big complaint is the RRIF withdrawal rates starting at 7.38% for 71 year olds and rising to 20% by the age of 94. They were set in 1992 when the average rate on long-term Government of Canada bonds was 8.7% and 3-month commercial paper was 6.7% (as I’m told). Interest rates are now a lot lower and people are living longer, so there is some concern about running out of funds too soon. Thus they argue minimum withdrawal rates should be lower. So does a study by the CD Howe Institute (in fact, they are open to abolishing them). Of course, current retirees may have known about the RRIF withdrawal rates at the time they made their RRSP contributions, but like the designers of the RRIF, they didn’t anticipate yields on bonds and GICs falling so low. Perhaps when the withdrawal rates were set, the designers should have included a feature to allow them to adapt to changing market conditions.

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  2. While I support the value of RRSPs, there's a big IF that you need to mention. Jerry could write a cheque for $6000 as an RRSP contribution or as savings. If he contributes to his RRSP, he can expect a $4000 tax refund. IF he also saves that $4000, he comes out ahead. If he blows it, he falls behind.

    What I've seen that works really well is when an employer makes payments directly to an RRSP, since they are not required to withhold taxes in this case. If an employer can't do this, I'd suggest filling out a form T1213.

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  3. I think you've hit it !! People either consciously or unconsciously think that it's "unfair" to have to pay taxes on untaxed income.

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  4. Excellent post, Michael.

    I see articles stating that TFSAs are superior to RRSPs or vice-versa and all I can think of is that the writer is lacking intelligence. :)

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  5. @Larry: I have no objection to tweaking RRSP rules to better handle changes in longevity. These proposals are well-thought out by people who understand what is going on. I was addressing the misunderstanding among a subset of the masses concerning the advantages of RRSPs.

    @Robert: It's certainly true that people can undermine any saving plan by wasting money. The person who has $6000 to save could put $10,000 in his RRSP and use the $4000 refund to "get back to even". This would eliminate the problem of wasting the tax refund.

    @Anonymous: Yes, by the time it comes to paying taxes, the past tax breaks are long forgotten.

    @Mike: There are cases where an RRSP or TFSA is superior, but many of the arguments people make are based on misunderstandings.

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  6. @Larry: I don't buy the "running out of money" argument. Just because you must withdraw money from an RRIF and pay tax on it doesn't mean you need to spend it.

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  7. In reality, he’d have less than $300,000 saved.

    RRSP-bashers miss this point as well. The tax shelter provided by a RRSP allows true compounding of returns. Not so in a taxable account.

    Thanks for the mention Michael.

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  8. @Patrick: True. I've tried to make the point myself that you don't have to spend money withdrawn from an RRIF. However, I don't object to lowering the mandatory withdrawals if it is coupled with other measures that effectively raise the retirement age in Canada.

    @CC: Tax-free compounding is very important, but widely misunderstood, as you say.

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  9. A great topic to blog about because many people, with or without RRSP's, don't fully understand the concepts. Take a look at the link I provided, these articles are very helpful as well! For your readers, use the RRSP calculator to try some numbers out!

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  10. I think folks who shouldn't leverage an RRSP as part of their retirement plan, are indeed in the minority.

    Regarding the RRIF withdrawal rates, they are quite high; folks will be depleting lots of capital if you're forced to withdraw at least 7% in year one (and it only gets worse with age).

    Most financial rules, as Larry said, made some 20 years ago should be revisited. Financial conditions evolve.

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