Wednesday, March 5, 2014

CRA: Your RRSP Partners Whether You Want Them or Not

Many people struggle to understand RRSPs. I’m going to try a different approach to explain how RRSPs affect taxes. This explanation is based on the idea that the Canada Revenue Agency (CRA) becomes a partner in your RRSP investment venture.

If you put $10,000 into an account, you think of it as entirely your own money. If it is a regular non-registered account, you’ll have to pay income taxes on any gains, but the original $10,000 is your money. Things aren’t so simple for RRSPs.

Let’s suppose that you’re in a 40% marginal tax bracket. This means that each added dollar of income you earn costs you 40 cents in incomes taxes. If you put $10,000 into your RRSP, you get to deduct $10,000 from your income, and your income taxes will go down $4000. But this isn’t free money; CRA just became your partner.

With that $4000 refund from CRA, they bought partial ownership of your RRSP. You can think of this as similar to running a business and selling part of it to a partner. Sometime in the future you will start drawing money from your RRSP (or RRIF if you’ve rolled it over). At this point, your partner, CRA, will want their share.

Even though you can barely remember getting your tax refunds and have long since wasted them on electronic gadgets or clothes, CRA is still your partner and expects its cut.

One important difference between your RRSP partner and a business partner is how we determine the percentage of ownership. In a business venture, if you put up $6000, and your partner puts up $4000, typically you get 60% of any eventual profits and your partner would get 40%. RRSPs work differently.

The price CRA pays to become your partner is based on your marginal tax rate at the time that you take the RRSP deduction. This was 40% in the example above. But the amount that CRA gets on a withdrawal is based on your (effective) marginal tax rate when you make the withdrawal.

So, if you take deductions with a 40% tax rate, but make withdrawal with a 30% tax rate, CRA pays for 40% ownership of your RRSP but gets only 30% of the spoils. This is a good deal for you.

However, it can work the other way around as well. If your income is so low in retirement that you collect the Guaranteed Income Supplement (GIS), your effective marginal tax rate can be 70% or higher. This means that CRA gets a bigger share of your RRSP than they actually paid for. How you and CRA fare all comes down to the difference between your tax rate at the time of taking the RRSP deduction vs. your tax rate at the time of withdrawal.

All this is why low-income Canadians with low income tax rates are often better off investing their savings in a TFSA rather than an RRSP. For someone with tax rates the same while working and in retirement, TFSAs and RRSPs will work out roughly the same. RRSPs have the added twist of being better or worse than TFSAs depending on how tax rates change from working to retirement.

Keep in mind that both TFSAs and RRSPs are a great deal for long-term savings compared to non-registered investments because TFSAs grow tax-free, and your share of RRSPs also grow tax-free. The drag of paying taxes on gains in a non-registered account builds up significantly over the long term.

So, the next time you hear retirees whine about having to pay taxes on RRSP or RRIF withdrawals, you’ll know that they took on CRA as a partner whether they realized it or not, and that they had the benefit of tax-free growth on their share of the RRSP savings.

15 comments:

  1. I did not realise the effect of "effective" tax rate in low income retirement. I suppose you refer to claw back effect. I knew the parts of the puzzle, but never cared to put them together and calculate the effective tax rate. Thank you for bringing my attention to this. I believe many would benefit from an example on that.

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    1. @AnatoliN: The term "clawback" is usually used in connection with taxing back Old Age Security (15% additional reduction) for those making more than roughly $71,000. I'm talking about reductions in the Guaranteed Income Supplement (GIS) which go to very low income retirees. In a certain range of income, GIS is reduced by 50% for each dollar of income. There are many other income-tested benefits that increase the effective tax rate even more.

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  2. Aha, another possible explanation for the name Canada Revenue Agency.

    Sandi Martin (Spring Finance) was wondering why they aren't called Revenue Canada. I thought it was perhaps so the acronym for Canada Revenue Agency paperwork would be appropriate.

    Apparently, based on your thoughtful insight, the accurate acronym is Canada Revenue Agency Partner. Makes sense!

    Either way, the acronym fits perfectly.

    I do like the silent partner analogy. Especially if we imagine that partner as weighing about 280 lbs and dragging his knuckles when he lurches....

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    1. @Bet Crooks: Thanks for the smile. I've had occasion to talk to quite a few CRA employees over the years, many of them well inside the usual call center layer. I'd have to say that overall, they are quite helpful and sympathetic. However, like most large organizations and businesses, employees take much of their direction from computers. Once CRA computers decide that you owe money, watch out.

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  3. The following comment from an anonymous poster seemed to get lost:

    "great post! i never thought about rrsp's this way but it sure makes more sense. i wonder if there are any benefits being partnered with the government --haha."

    @Anonymous: Thanks. I'm reminded of the joke "just be thankful you don't get all the government you pay for." On the other hand, our government does a lot for us. We haven't been invaded lately, and my house hasn't been broken into by roving bands of starving people. Government deserves some bashing for extreme inefficiency, but the services they perform are mostly vital.

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  4. I think overall the government is a very patient partner indeed in the case of RSPs. If we invert the partnership a little: would I be willing to pay someone 40% up front for a 30-70% portion of earnings that I had to wait 35 years to collect? Probably not, especially when I suspect my partner is likely going to buy high-expense mutual finds or low-yielding GICs. In short, my partner is probably a bad investor, and I'm going to have to wait a long time. Bad deal.

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    1. @Gene: Agreed. This deal would look more attractive if I could simply change the rules to get more money for myself when I feel like it.

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  5. For those with significant contribution room, this also highlights the benefits of using the "gross up" strategy to make sure you're maximizing the tax benefits of your refund. Useful recent article on that subject here:

    http://www.thestar.com/business/personal_finance/2014/02/19/how_to_supercharge_your_rrsp.html

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    1. @Juan: This strategy involves borrowing to contribute to an RRSP, which can work well for some people, but can lead to a debt slide for others. The article's example has you holding $3000 to contribute to your RRSP, and you borrow $2000 to be paid off when you get the $2000 tax refund (40% marginal tax rate assumed). I prefer a safer solution. Contribute the $3000 now. This generates a $1200 tax refund. Contribute that $1200 when you get it. Then contribute another $3000 next year (or whatever you're able to save). Your next tax refund is up to 40% of $4200, which is $1680. Contribute that amount when you get it. Over time you'll get to almost the same point as the borrowing strategy without the risk of getting caught with debt if you lose your job or get sick, etc.

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    2. Good advice. Though I don't mind the short-term loan part as I find it helps to eliminate any temptation to spend or otherwise misuse the refund - I create a debt for myself which I'm very eager to pay off. But I see your point about job loss or illness.

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  6. So when I hear blanket statements like, "Maximize your RRSP, then your TSFA, and then invest in Index Funds", I should by wary?

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    1. @Paul: You should decide whether to save in an RRSP or a TFSA based on your current marginal tax rate and your expected marginal tax rate in retirement. This choice can change from year to year for some people. The part about investing in low-cost index funds is a good idea for almost everyone.

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  7. Here is a great calculator that is relevant to your article.

    http://www.retirementadvisor.ca/retadv/apps/tfsaRrsp/tfsaRrsp_inputs.jsp?toolsSubMenu=preRet

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  8. The CRA truly is a partner since it takes a loss if you happen to mess up and actually lose money. CRA earns the same return as you do.

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