Tuesday, March 11, 2014

Debunking RRSP Myths with Pictures

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.


  1. Nice single year analysis. Here are 2 challenges for you:

    1- Do 10, 20, 30, and 40 year analyses. (10 and 20 for pre-retirement, 30 and 40 for a complete investing cycle, including pre and post-retirement).

    2- Explain in what scenario an investor (with some savings capacity, ruling out the poor) would end up with a higher marginal rate in retirement, other than with inheritance, lottery, or important tax rule changes.

    My guesses are that:
    1- The tax-advantage of RRSP and TFSA over taxable gets bigger with time.
    2- For the vast majority of Canadians, they'll have a lower marginal tax rate in retirement. Once exception: the very rich which, anyway, will fill up both their RRSP and TFSA and have additional money spilling out into taxable investments. (I assume that young workers doing part-time work while studying don't have the capacity to invest. Any savings they do should be put in a savings account and kept for emergencies).

    1. @Anonymous: I don't find this stuff all that challenging. My goal is to explain it so that others can understand better. Unfortunately, longer analyses become a sea of numbers that speak to me and many of my readers, but I was trying to reach a broader audience here.

      1. You're right that the tax advantage of RRSPs and TFSAs build significantly over time.

      2. Many people see their marginal tax rate jump around throughout their working lives. So, you need to look at each year's savings in isolation. While your tax rate in retirement may be lower than your average tax rate while working, you may have working years where your marginal tax rate is quite low. In these years it makes sense to use a TFSA rather than an RRSP (or defer using the RRSP deduction). In rare cases, it can make sense to use a non-registered account if your TFSA is full.

      One other possible reason for your effective tax rate to be higher in retirement is the 15% OAS clawback.

    2. Lucky you; it would be challenging to me. :)

      Right, I forgot about OAS. All the more reasons for another of your nice posts in the future.

    3. @Anonymous: Here's a fairly simple 40-year scenario. Start with $6000 ($10,000 in an RRSP). Buy a stock that pays no dividend and makes 5% per year. In the TFSA case, you end up with $42,240. After taxes, the RRSP gives the same. After capital gains taxes, the non-registered account gives $34,992.

      This is the most favourable case for a non-registered account. It's final balance would be less if the capital gains were realized a few times over the 40 years. If the income were dividends each year, the final after-tax non-registered account balance would be $28,439.

    4. I know of a situation in which you can have a higher tax rate in retirement: spousal RRSPs. Even without using these, with a large difference between spousal incomes, both can max out RRSPs and TFSA room, leaving the lower-income spouse withdrawing more in retirement than s/he made while working.

    5. And come to think of it, couldn't this lead to a situation where the higher overall tax rate resulted from withdrawing from RRSPs in retirement rather than a lifetime of negative-rate eligible-dividend collecting from an unregistered account? Or am I thinking about this completely wrong?

    6. @Unknown: What you describe could happen, but you'd have to be pretty determined to use spousal RRSPs the wrong way. If the lower-income spouse were to contribute to the higher-income spouse's RRSP, this could happen. But I hope there aren't any people out there making this bad a mistake.

    7. Hmm, maybe I am thinking about this wrong then. My husband and I find ourselves in this situation... his income is about 3x more than my own but our plan is to have equal incomes in retirement, so it is he who contributes to my spousal RRSP.

      After maxing the RRSPs and TFSA, we have extra retirement savings going into my unreg account (mostly VDY) so I can enjoy the negative dividend rate (we have no debts to apply this extra money to). It had occurred to me while reading this article that maybe I should do some calculations to figure out whether it might be reasonable to divert some of my RRSP portion to the unreg account for an overall lower tax rate (even taking the eventual capital gains into account). If I'm wrong about this, can you show me where I've gone astray?

    8. I should probably clarify that as a result of his contributions to my sRRSP and our withdrawing equal amounts in retirement, that my retirement income will probably be 15-20% higher than it is now, but his will be much lower (which will make my slight increase worth it).

      Unless, of course, I have my head screwed on completely backwards about how this would work, tax-wise.

    9. @Unknown: OK, I think I understand better what you mean. From what you've said, it seems likely that your tax rate in retirement will be less than your husband's current tax rate. So, it's likely that you're better off continuing with the spousal RRSP contributions. If your effective dividend tax rate is really negative, then it might make sense to divert some TFSA contributions to your non-registered account. However, this is only true if they are your savings and not your husband's. He has to pay taxes on income from your non-registered account if he earned the money in it. Also, be sure that your effective dividend tax rate is really negative. In a certain range of your income your husband loses the spousal deduction, making the effective tax rate higher. If it really makes sense to divert some TFSA contributions to your non-registered account, it will only make sense for a while until your income grows to the point where the dividend tax rate becomes positive again.

    10. Thanks, your points are well taken. I do make more than the spousal amount, so he already loses out on that.

      Would it be considered fair to invest (in my name alone) up to, but not more than, my annual income per year? i.e., we live on my husband's income and invest mine. Or is that considered suspect by the CRA?

    11. @Unknown: My wife has saved and invested all of her income for many years. But it has always been her actual income. We never mix it with my money. If you mix your money together it may be harder to make the case that you've saved only your money.

    12. Thanks for your input... that's something I'm definitely going implement going forward!

      I guess my overall point (beyond the discussion of my personal situation) is that many of the articles comparing TFSAs, RRSPs, etc and overall investing strategies seem to assume that each investor is single. This makes situations like mine nearly impossible (having a low salary and lower tax rate now than at retirement) except for the fact that I have access to 2 sources of income when planning the most efficient retirement strategy.

      Perhaps an analysis on retirement vehicles for couples in the future? Particularly those with significantly different incomes who can take some advantage of alternative strategies.

    13. @Julie: I'm actually in a similar situation to yours. One difference is that my wife makes enough that here effective tax rates on dividends is positive. I'll think about whether it makes sense to describe what we do in a future post. However, I would never claim that anyone else should blindly follow what we do. Other people's situations may be different in some important way, and I certainly don't have it all figured out.

    14. Correct me if I'm wrong, but I believe it doesn't really matter in retirement whether money was put into the RRSP of the high-earner or lower earner because when paying taxes in retirement you can re-allocate some or all of the income to your spouse to minimize overall taxes.

    15. @Steve88861: If you're 65 you can split RRIF income with a spouse (up to 50% of the income). So, you can't do any splitting before age 65, and you can't share more than half the income. To many people, these restrictions don't matter, but they do in some situations. For example, those who retire young or those who have significant income from a taxable account and would want to allocate more than half the RRIF income to a spouse.

  2. Hi,
    Ok, I've really fried my brain this time. Can you help me double check some math?

    I'd like to add 2 more examples to a variation of the first scenario.
    (and yes, the end result is basically the same as what you have so no worries there for me.)

    My variation on your first question is:
    What if Ami didn't have $11 000. What if she only had $6000? Leaving out the car etc, she just has $6000 to invest in one of the three ways.

    If she went the TFSA route, you've shown me she would have $6300.
    If she went the non-registered route, you've shown she'd have $6240.

    My additional 2 scenarios are:
    She puts 6000 in her RRSP. She gets 2400 back in a tax refund.

    a) She then invests the 2400 back into her RRSP (unlikely if like me she has no room left after her annual contribution) or
    b) she invests the 2400 into a non-registered account.
    I didn't bother including investing the 2400 in a TFSA. It's obvious any investment in a TFSA wins.

    If she does the RRSP/non-reg account version, does she end up with:

    3780 of her own money in the RRSP
    2520 of the government's money in the RRSP

    2496 of her own money in the nonreg account
    24 of the governments cap gains tax money in the nonreg account

    for a total to her amount of 6276?
    (NOTE this is still better than the nonreg only option of 6240 in your example above)

    and for the RRSP and back into the RRSP version

    5292 of her own money in the RRSP and
    3528 of the government's money in her RRSP
    PLUS another 960 of her own money from the second income tax refund which I gave up on trying to reinvest and kept in cash?
    meaning she would have 6252 ish of her own money (actually more depending on when/where she reinvested it)

    So overall her best choices would be:
    1. TFSA
    2. RRSP plus non-reg
    which is probably tied with RRSP plus second RRSP plus cash (because I didn't keep reinvesting the refunds far enough)
    3. NonReg

    It is critical to re-invest that tax return from the $6000 into the RRSP. Otherwise she gets the $3780 from the RRSP and only the tax refund of the $2400 which is only $6180.

    I'm hoping my math is working because frankly I inhaled way too many Zamboni fumes this week so I'm not sure.

    Does this make sense?

    1. @Bet Crooks: Your numbers for scenario a (3780, 2520, 2496, 24) look right to me. Scenario b numbers look good too. You're right that there are follow on tax rebates of $960, $384, $153.60, ... in subsequent years.

      The best choice is roughly a tie between TFSA and RRSP+RRSP+RRSP+...(over many years). This is true if you have the RRSP room and your tax rate is the same while working as it is in retirement.

      The next best is RRSP + non-reg, and last is non-reg.

    2. Thanks! I'm glad my brain isn't totally frozen.

    3. +1
      I think the $6000 only (with RRSP refund) is more applicable to people.

    4. @aB: I would agree if you take into account all future effects. The RRSP refunds lead to a cascading set up refunds year after year. If not, then we have a situation where someone needs to spend their refund. In the TFSA or non-registered account cases where there is no refund, this means making a withdrawal from savings to spend.

  3. Great post. Only thing you cant quantify is whether people are more tempted to take their retirement money from a TFSA than a RRSP because of the ease of access?

    1. @Mark: You're right that there are important behavioural issues to consider that may trump small differences for rational investors. However, if you've managed to save anything at all, you've already beat some behavioural issues.

    2. But you also cannot quantify peoples' temptation to spend the refund, which is the key factor in RRSPs being effective. I think people would be more likely to spend their refund than withdraw from a TFSA.

    3. @Anonymous: If you don't count the refund, then you are quantifying it even if you don't realize it. You are valuing the refund at precisely zero on the assumption that it gets entirely wasted, which is rarely the case. I'm open to other reasonable analyses, but any analysis that simply ignores the refund is obviously wrong.

  4. Another tax advantage the RRSP might have is that withdrawals can be managed to keep them at a lower marginal rate. In an extreme case where a large capital gain is realized in one year this could make a big difference. Other than that it would mainly apply to people who who investment income well above their spending needs or have occasional years with very low income.

    If someone does have a low-income year before they retire, they would then have to decide if it's worth moving some of their assets out of the RRSP since they are very likely to face a higher marginal rate later.

    1. @Richard: True. To the extent that you can manipulate the average tax rate on contributed dollars upward and manipulate the average tax rate on withdrawn dollars downward, the RRSP looks better.

  5. For myth 1, I think the difference maker (as you mentioned) is the difference in marginal tax rates over time. From what I've come across most people (including myself) are in a higher marginal rate when they're working than when they retire. In this case an RRSP makes more sense than TFSA (or non registered). Sure, the full amount of a gain may be taxable within an RRSP but the difference in marginal rates (assuming a higher rate now than in retirement) more than makes up for the difference

    1. @Dan: In fact, even if your marginal tax rate stayed exactly the same, the RRSP and TFSA cases work out the same. A dropping marginal tax rate is an added bonus for RRSPs.

  6. Another way to argue the same points is to dispute the claim that profits earned in the registered accounts are taxed on withdrawal. They need that presumption for their argument (that the deferral of a preferential tax rate is worth less than the eventual 100% tax rate on the profits at withdrawal).

    Yes, RRSP withdrawals are taxed, but you cannot say that the profits earned in the account are taxed. The tax $$ are an allocation of principal. They are paying back to the government its original loan to you plus all the income it earned. Watch the 2nd video of the series https://www.youtube.com/channel/UCYf70uCj5q4GRWYC0wVtdxg

    1. @Retail Investor: Once people get the idea that a fraction of their RRSP contents isn't really theirs, the next logical conclusion is that the RRSP profits on the part that is theirs isn't taxed.

  7. In assessing the advantages and disadvantages of investing in a RRSP vs TFSA vs Non-Reg Acct, one has to deal with the tax hit on RRIFs, for most RRSPs get converted to RRIFs. The tax hit on RRIFs, taking out each year just the required min withdrawal, increases with age and with increasing RRIF market value. That is not so with a Non-Reg Acct. This is a big negative for putting money into a RRSP if one assumes that the RRSP gets converted to a RRIF. See this by Jonathan Chevreau: http://www.financialpost.com/personal-finance/rrsp/RRIF+rebels+take+RRSPs+dark+side/4185870/story.html

    1. @Vinnie: You are misunderstanding the FP article you pointed to. It's true that many people would like to reduce the forced RRIF withdrawal rates. However, this would just make the gap between RRSP and non-registered accounts even bigger. RRSPs/RRIFs are a better deal than non-registered accounts under the current rules. People can be fooled into thinking this is not the case when they look at a comparison where the start both accounts with the same savings. But this isn't realistic. The tax break on RRSP contributions and the tax-sheltering of gains mean that with the same hit to cash flow you will certainly build more savings in an RRSP than in a non-registered account. This larger RRSP balance will more than compensate for the added taxes that come later on the RRIF.

  8. So your advice would be to max one’s RRSP and TFSA first and then if one has money left over to invest, invest in a Non-Reg Acct?

    When I was working (I’m now 82), I did not want to touch a Non-Reg Acct because I got no contribution refund and had to pay taxes on it every year. But when my parents died twenty one years ago, I inherited a Non-Reg Acct. And then looking at the taxation on it and one of my RRIFs with comparable distributions and comparable market values, it’s very easy to be mightily impressed by the small taxation on the Non-Reg Acct owing to both the div credits plus in the years before the income trusts were closed down the very large returns of capital. That impression can lead one to draw some wrong-headed inferences as to the relative values of the two kinds of investment accounts.

    I suppose you noticed that John Heinzl, in yesterday’s G & M, has an article making many of the points you do. A reader in commenting on Heinzl said in effect that Heinzl was old hat and that you had covered all this in more detail.The reader provided a link to you. And that ’s how I got to read you. You set the matter out very well and the diagrams help.
    And it's just A+ that you respond at such length to those who write in.

    I’m glad I discovered your blog.

    1. @Vinnie: I'm usually careful not to give explicit advice because you never know all the details of another person's finances. However, it's true that using a TFSA is almost always better than a non-registered account, and as long as your tax rate doesn't go up significantly from your working life to retirement, an RRSP is almost always better than a non-registered account.

      Yes, these "wrong-headed inferences" usually come from forgetting that the RRIF balance is higher than a non-registered balance would have been.

      I hadn't seen Heinzl's article yet -- thanks for pointing me to it. Thanks for the A+. I've learned quite a bit from my readers over the years and responding to them is one of the joys of blogging.

  9. Michael: What's wrong with this?

    Which is more tax efficient — a RRSP, a TFSA, or a Non-Registered Account (a NRA)?


    —Just prior to the deadline for RRSP contributions, all three accts are empty.

    — just prior to that deadline, $15K was put into each of the three accounts and the same stocks in the same amounts were purchased for all three.

    — the investor’s income tax rate is 40%. So he got a $6K refund for the RRSP contribution which … he put into the RRSP the DAY the refund was available. That $6K was used to buy more of the same stocks in the same proportions.

    —after 12 months from the DAY, each account has appreciated in market value by 5% and has returned 3% in eligible dividends

    — at the end of 12 months from the DAY, all securities in each acct are sold and taxes owing are paid. Which account then produces the most after-taxes cash?

    The RRSP: $21K to start. At the end of the 12 months, market value = $21K + ($21K x 5%) = $22, 050K. Dividends = $21K x 3% = $630. Cash out at the end of the 12 months = $22, 050K + $630 = $22, 680. Taxes = $22, 680 x 40% = $9072. Return net of taxes = $22, 680K - $9072 = $13, 608.

    The TFSA: $15K to start. At the end of the 12 months, market value = $15K + ($15K x 5%) = $15, 750. Dividends = $15K x 3% = $450. Cash out at the end of the 12 months: $15, 750 + $450 = $16, 200. Return net of taxes = $16, 200.

    NRA: $15K to start. At the end of the 12 months, market value = $15K + ($15K x 5%) = $15, 750. Dividends = $15K x 3% = $450.

    Taxes on Cap gain of $750 = taxes on half $750 at 40% = $150
    Taxes on eligible dividends of $450 at 23% = $103.50.(23% is the approximately the combined federal and MB rate for 2014 and 2015. See TaxTips.ca))
    Return net of taxes $15, 750 - ($150 + $103.50) = $15, 496.50

    So the TFSA wins while the NRA comes in second, and the RRSP third.

    1. @Vinnie: The thing I see missing is the $2400 tax refund from the $6000 RRSP contribution bringing the RRSP return up to $16,008. This leaves us with TFSA first, RRSP a close second, and non-registered account third. This small difference between the RRSP and TFSA comes from the delay in getting a refund, re-contributing the refund, and getting the next refund, etc. Over many years, this difference between RRSPs and TFSAs is small. A much more important factor is whether your tax rate goes up or down when you start withdrawing from an RRSP/RRIF. In almost all circumstances, though, the non-registered account loses to both RRSPs and TFSAs by quite a bit in the long run.

  10. Another consideration when choosing between TFSA and RRSP is whether you would prefer to:
    1. Pay taxes on your income now, be done with it, and go and make your own profits.
    2. Pay taxes on your income later, giving the government a stake in your investments.
    I prefer choice 1, since that eliminates the uncertainty of what my tax rate is going to look like decades in the future, and I have a hard enough time getting that income out of the government in the first place. I don't have any desire to cut them in on the profits I (hopefully) make.

    1. @Anonymous: If you're concerned about governments increasing tax rates significantly in the future then this makes some sense. However, the desire not to cut the government in on future profits is often based on the misconception I tried to explain in this article. Would you like to have $6000 to invest and keep the profits, or would you rather have $10,000 to invest but have to give the government 40% of the profits? I see no reason to prefer one over the other.

    2. The preference comes from a general distrust and dislike of the government. It's more psychological than mathematical. I don't trust the government to not hike taxes in the future, nor would I want to partner with them. I understand other people will have a different view on this, but it is something to consider.

  11. I think I have a different scenario not explored. I raided my RRSP via the Home Buyer's Plan (HBP) to buy a house two years ago. I have to repay 25,000 over the next 15 years, starting this year. I will be repaying the minimum this year, but - and this is key - next year I will have my TFSA & RRSP contribution room maxed, with money still left over to invest.

    So then I will have to make a decision on whether repay my Home Buyer's Plan amount back into my RRSP early, or invest in a non-registered account and just continue repaying my HBP amount over the 15 years allocated for repayment.

    Essentially, this problem is like your first example, except I won't receive the tax refund to re-invest when I re-pay (I already have received the refund). I believe you could look at it like I'll eventually be paying capital gains tax on 100% of this repayment.

    When I try to boil it down to the basics, I come up with this quandary: is it more tax efficient to pay immediate capital gains tax on dividends and eventual 50% capital gains tax (non-registered), or just eventual 100% capital gains tax (RRSP HBP repayment) ?

    1. @Garry: The part you haven't mentioned is the income taxes you would have to pay if you don't make the HBP repayment. You would be, in effect, giving back the tax break you got way back when you first contributed the money to your RRSP. So, if you make the HBP repayment, you save yourself from paying these taxes. For this reason I don't agree that you'll "eventually be paying capital gains tax on 100% of this repayment."

      When you consider all the side effects of making the repayment or not, the difference between the two choices is the same as the difference between making an RRSP contribution and not making a contribution.

    2. Sorry Michael, I wasn't clear. I will be making the repayment. The question is whether repay over 15 years, or repay the entire amount in 2015, 2016 and 2017, as I will have the funds available.

      So, repay early, or not?

    3. @Garry: Okay, I get what you mean now. There is a bias towards making the whole repayment sooner (if you have the money) because then the growth on the portion that is yours (and not the government's) will grow tax-free. If you expect to have future years with a low marginal tax rate, the calculation is more complex, but you could always just withdraw the money again in these future years. I haven't thought this through in full, but I'd be surprised if paying it all back now isn't the best choice.