Wednesday, April 21, 2010

A Proposed Break on RRIF Withdrawal Taxes

Andrew Dunn of Deloitte Canada has some ideas quoted at the Wealthy Boomer on changing the way RRIF withdrawals are taxed. On the surface these ideas seem to make a lot of sense, but on analysis, the reasoning breaks down.

As things stand now, when you pull money out of an RRSP or RRIF, the amount gets included in your income for the year. Over the years this tax-sheltered money grows through capital gains, dividends, and interest, but none of that matters when filing your taxes; all withdrawals become regular income that is taxed at your top rate.

Dunn suggests that the type of returns should be tracked so that when you withdraw the money, it gets taxed as capital gains, dividends, and interest so that some of it will be taxed at lower rates.

This seems reasonable at first, but it ignores the real nature of RRSPs. An RRSP is a vehicle for deferring taxes. Your contributions are untaxed in the year you make them and get taxed when you withdraw them.

Let's consider an example to illustrate why the current system makes sense. Sally opened a new RRSP with a $10,000 contribution. Her marginal tax rate is 40%. If she hadn't made the RRSP contribution, she would have kept $6000 and paid $4000 in additional income taxes.

Sally should think of the $10,000 sitting in her RRSP as being $6000 for her and $4000 for the government. In this sense, $6000 in a TFSA has about the same value to Sally as $10,000 in an RRSP (assuming her tax rate is also 40% when she pulls money out of the RRSP).

Fast-forward 25 years. Sally's $10,000 has grown to $100,000, and her marginal tax rate is still 40%. This money is still only 60% hers. The whole amount grew by a factor of 10, and her portion grew by a factor of 10 from $6000 to $60,000.

If we focus on Sally's portion, it has grown completely tax-free. The growth of the government's portion will cover the taxes owing. So she will get all of her portion over time without having to pay any additional taxes on its growth.

Any further tax breaks Sally might get along the lines of Dunn's proposal are outside the intent of RRSPs. Additionally, the complexity of tracking the nature of all the gains would be a burden.

If the government wants to give additional tax breaks to people making withdrawals from RRSPs and RRIFs, something simple like making the first $3000 withdrawn each year tax-free is preferable to Dunn's proposal that would require significant accounting information to be retained for decades.


  1. Thank you for being one of the few people who seem to understand the RRSP system as an income deferral system. The tax break was supposed to be that you would take the income in your retirement years when your marginal tax rate would be lower. Changing the rules now would allow a form of double dipping.

    I would be upset if these rules changed. I have made decisions not to invest much in an RRSP based on the rules as they stand. Changing the rules would give unfair advantage to others, and penalize me because I would have to pick up a greater share of the government's expenses through my taxes.

  2. It's an interesting concept Mr. Dunn proposes, but the bookkeeping is where it would fall to it's knees.

    Making the RRIF income, tax free in small amounts might be an interesting way to deal with it. Might be more interesting if you lost money on investments in your RRSP, if that loss increased your RRSP room (if I lost $2000 on a stock sale, my RRSP limit for the next year would be goosed up $2000), but again, the bookkeeping on this might be horrendous as well.

  3. @Omarf: You make a good point. Significant changes to RRSP rules amount to a retroactive punishment for those who optimized their finances based on the original rules.

    @Big Cajun Man: I suppose that someone would benefit if we all had to keep track of significant amounts of accounting information for decades. However, this would benefit a few at a much larger expense of many.

  4. @CC: Hilarious! I'm starting to get tired of the number of proposed tax changes I see that clearly favour old rich people. Most of these proposals would benefit me, but they still bother me partly because they seem like bad policy and partly because they are dripping with unmasked greed.

    1. The comment above is a reply to Canadian Capitalist's comment:

      My feelings about this are summed up perfectly by this comment on the Wealthy Boomer:

      " Oink Oink! I saved my money in an RRSP and I knew the deal going in and I enjoyed the deduction from income at that time. But Oink Oink, I now want a better deal.

      And, you know, I can't save a dime in a normal non-registered account. I am addicted to tax breaks. Oink Oink!

      Let someone else pay the tax! Not me!"

      Couldn't have put it better myself. Oink! Oink!

  5. Many individuals don't understand the RRSP system at all. They don't think it's fair that they get taxed on the money when it is withdrawn. Often I hear people say that RRSPs are a rip-off so they don't bother to put money into them. Opinions such as this make me crazy and no amount of explanation convinces these individuals to change their minds.

    Michael, I love your simple explanation on the RRSP system and am totally in agreement that it shouldn't be changed. As someone who is getting closer and closer to RRIF time, I also like your idea of allowing a small amount to be withdrawn tax-free.

  6. @Maltese: For some very low income people, avoiding RRSPs can make sense because of the GIS clawback. However, I suspect that the majority of people who avoid RRSPs do so for much simpler reasons. Two that come to mind are 1) saving is hard, and 2) anything other than cash in a bank account is complicated and scary.