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.