Thursday, January 21, 2010

Should You Save in RRSPs or Not?

“Is it better to just invest and pay your taxes now or is it better to invest through RRSPs? Or are they about the same return?”

This question came from a reader, Dan, who I met when I spoke to the Ottawa Share Club.

Most people focus on the immediate tax refund from making RRSP contributions, but this is really just a tax deferral. You will have to pay these taxes when you eventually withdraw the money. If your tax rate is lower when you withdraw the money, you end up saving on taxes, but this is not the primary advantage of RRSPs.

By deferring taxes you get the benefit of having the returns on your savings compound tax-free. If you invest in a regular taxable account and pay the taxes owing each year, you lose out on much of the compounding. An example will illustrate this nicely.

Example

Rhonda is 25 years old. She plans to open an RRSP and contribute \$10,000 this year and increase this amount by inflation each year for a total of 40 years. This year she’ll get a \$4000 tax refund making the net cost to her this year \$6000.

Thomas is also 25 years old. He plans to open a taxable investment account and deposit \$6000 this year and increase this amount by inflation each year for a total of 40 years. Thomas plans to pay any investment taxes owing out of his savings each year so that his net cost will be the same as Rhonda’s net cost.

Both investors will retire at age 65 and withdraw a fixed after-tax amount each year (rising with inflation) that will exhaust their savings after 25 years.

The question is: who will get the larger retirement income? To answer this, we’ll have to make a series of assumptions.

Assumptions

Taxes: To isolate the benefits of compounding in RRSPs, we will assume that both investors have constant tax rates throughout their lives: 40% on regular income, 20% on capital gains, and 13% on dividends.

Inflation: 3%

Returns: Both investors have a mix of stocks and bonds that earn 7% per year (4% capital gains, 2% dividends, and 1% interest).

Turnover: Both investors change 20% of their investments each year. This doesn’t affect Rhonda much, but it causes Thomas to pay some capital gains taxes each year.

Results

The costs to both investors are the same, and if both approaches were equally good, then we would expect both Rhonda and Thomas to have the same income in retirement. But that’s not how it works out. After fighting with Excel for a while, here are the results:

Yearly after-tax income in retirement in today’s dollars:

Rhonda: \$35,074
Thomas: \$22,861

This is a big difference that we can attribute to the power of tax-free compounding. Any advantage due to having a lower tax rate in retirement would be extra.

The main message is that if you have a long investing horizon, RRSPs can give a big advantage. Tax-Free Savings Accounts (TFSAs) have this advantage as well.

1. Your post clearly shows the advantage of deferring taxes. And like you mention, the numbers understate the advantage of RRSPs because a retiree's tax rate may drop a level or two. The difference is stunning really: Rhonda has 50% more income than Thomas under identical return conditions.

2. CC: The advantage of RRSPs (or TFSAs) is related to the cumulative return over the investing lifetime. This means that the longer your investment time horizon and the better returns you make each year, the bigger the advantage of using RRSPs and TFSAs versus a taxable investment account.

3. You do public speaking engagements?

4. Big Cajun Man: Anyone I speak to in person gets to know my real identity.

5. Michael
Could you also do a comparison between a Buy and Hold strategy with reinvested dividends. Additional funds to add to existing holdings and no capital gains until funds required as income (or any income required over and above dividend income if that is used at retirement as well).

Big Cajun Man: Michael put on his 'normal and unassuming' guise when he spoke with us. Not sure about the real identity!!!

6. James: It's not clear to me exactly what comparison you're looking for. Is it a comparison of RRSP versus a taxable account where the investment strategy in each is dividend-based stocks where dividends are reinvested and there is no stock turnover? If so, all I would have to do is change the return assumptions to eliminate interest income, increase dividends, and reduce capital gains.

In case that's what you're looking for, I made the following changes to my spreadsheet:

Capital gains: 3%
Dividends: 4%
Interest: 0%
Turnover: 0%

The retirement income (in today's dollars) for the RRSP account remain unchanged at \$35,074. For the taxable account, the income is \$28,922. So, there is still significant advantage to using this strategy within an RRSP. This test may have understated the advantage because it isn't realistic to have no stock turnover in 65 years of investing.

7. I would find it very interesting to compare investing in the RRSP to paying down a mortgage with a rate between 5-6%.

I do hold RRSP's and have a defined benefit pension plan so right now the plan is to get my mortgage paid off asap.

8. No Debt Guy: I can't think of a meaningful way to compare paying down a mortgage versus investing within an RRSP. It would all depend on assumptions about interest rates and returns. For what it's worth, I'm a fan of paying down mortgages. I did away with my first mortgage in 4 years.

9. Could you extend this out to include after tax retirement income, and also include government benefits?

I just think that with the non registered income being taxed at lower rates he may be eligible for more government assistance, and also his tax rate would be far lower. The person taking the 35K out of their RRSP will be taxed at the marginal rate. Will their quality of life be that much different in retirement?

Also, compare this with a person who simply took the 6K and went on a cruise each year of their life? What will they get in retirement having no investment income but have full CPP/GIS/OAS after taxes and benefits.

I think this would be a far better comparison.

10. Traciatim: The figures are after-tax income. So, the \$35,074 after-tax income from the RRSP is actually a withdrawal of \$58,457. The effect of CPP/OAS/GIS can be complex, but it is likely that the overall tax rate on the RRSP withdrawal will actually be less than 40%. The advantage of the RRSP approach over a taxable account is likely to be even more than it appears from the numbers in my example.