There are persistent myths about the tax-inefficiency of RRSPs. Here I debunk these myths using pictures.
Myth 1: It is more tax-efficient to earn capital gains in a non-registered account than it is to earn them in an RRSP.
A typical justification for this belief is that in a non-registered account only half of the capital gains are taxed, but all of an RRSP withdrawal gets taxed.
To explain why this is a myth, let’s enlist the help of a hypothetical investor Ami. Five years ago Ami bought a house on her own and was somewhat house-poor until a promotion and raise two years ago. Since then she has managed to build $11,000 in a savings account without adding any debt beyond her mortgage. Ami plans to use $5000 of her savings toward a used car this summer, but she wants to invest the remaining $6000 for the long term. She is trying to choose among an RRSP, a TFSA, and a non-registered account. Within the account, Ami intends to invest with a goal of earning capital gains.
We’re going to run three different futures for Ami, one for each of these accounts. For the TSFA and non-registered account cases, the starting point is simply $6000 invested in each account. But, the RRSP case is different because Ami will be getting a tax break on her RRSP contribution.
Let’s assume that Ami’s marginal tax rate is 40%. Then she can contribute $10,000 to her RRSP and get a $4000 tax refund in time to buy her used car this summer. Even though Ami will have $10,000 in her RRSP, her net cash out-of-pocket is still just $6000, which is the same as the TFSA and non-registered account cases. Here is what each case looks like:
In the RRSP case, we have labeled the extra $4000 as belonging to the Canada Revenue Agency (CRA) because Ami would have to pay this much in taxes if she were to withdraw all the money from her RRSP. If we focus on just the money that belongs to Ami, she has the same $6000 in all three cases.
Fast-forward to the end of 2014. Ami’s investments have earned a 5% capital gain. Here is the new situation for each type of account:
In the TFSA, Ami now has $6300. The non-registered account has this much as well, but some of it will be taxed away when she sells her stock and realizes the capital gains. Canadians include half of a capital gain in their income. With a 40% marginal tax rate, Ami pays 20% taxes on capital gains which is $60 in this case.
In the RRSP case, Ami’s share and CRA’s share each earn their own capital gains. Ami now has $6300 and CRA now has $4200. This makes sense because if Ami were to withdraw the entire $10,500, she would have to pay $4200 in taxes.
If we compare each of the accounts, we see that Ami’s share of the RRSP is exactly the same as her TFSA assets. The only case that looks different is the non-registered account where income taxes have taken a bite. This shows it is not more tax-efficient to earn capital gains in a non-registered account than it is to earn them in an RRSP.
There is an added complication if Ami’s marginal tax rate changes when it comes time to make RRSP withdrawals. If Ami’s tax rate is lower than 40% when she withdraws money from her RRSP, she will get even more than she does with a TFSA. On the other hand, if her effective tax rate is higher, she gets less. The following figure shows the possible shift in assets to or from Ami depending on tax rates:
It is tax rates that determine whether an RRSP or TFSA will work out better for Ami, but the drag of capital gains taxes in non-registered accounts makes them a worse choice than TFSAs and usually worse than RRSPs.
Myth 2: It is more tax-efficient to earn dividends in a non-registered account than it is to earn them in an RRSP.
The typical justification of this myth is that in a non-registered account, you get the tax break from the dividend tax credit, but all of an RRSP withdrawal gets taxed.
Let’s continue with our friend Ami, except that now she is aiming to earn dividends instead of capital gains. Here is what her accounts look like at the end of 2014 after earning a 5% dividend:
This should look very familiar because it’s similar to the 5% capital gain case. The main differences are that Ami’s dividend taxes are slightly higher and they must be paid each year (capital gains get deferred until the gain is realized).
This tax drag has a cumulative compounding effect that builds up very significantly over time. A TFSA is far preferable for dividends, and except for the most extreme cases of higher tax rates in retirement, a long-term RRSP is preferable to a long-term non-registered account. Once again, we find that the tax-efficiency of dividends in a non-registered account versus an RRSP is a myth.
At their core, these myths come from the fact that RRSP savings get pumped up by tax refunds that people forget about, and they start to think of their RRSP balances as entirely their own money. Unlike TFSAs and non-registered accounts, RRSP deposits aren’t entirely your own, but you get higher RRSP balances for the same out-of-pocket contribution.