The Value of Delaying RRSP Withdrawals

We’ve heard that melting down an RRSP early can be valuable when it lowers your future tax rate on RRSP withdrawals later in retirement.  But we’ve also heard that delaying RRSP withdrawals so the RRSP can continue growing tax-free is valuable.  But not everyone agrees that longer tax-free compounding is valuable.  Who’s right?  Let’s dig in.

We can make mistakes when we try to measure the value of some portfolio choice in isolation.  We have to consider all of its effects to draw a correct conclusion.  Here’s an example:

Scenario 1 (RRSP meltdown): You withdraw an amount M from your RRSP today.  If your average tax rate on the withdrawal is T, you get to keep M(1-T).

Scenario 2 (no RRSP meltdown): In a second scenario, you delay RRSP withdrawals for a decade.  Your RRSP grows by a factor of R in that decade, and you withdraw MR then.  If your future average tax rate on that withdrawal is U, you get to keep MR(1-U).

It’s important to note that with T and U, we are not comparing tax rates on RRSP contributions while working to RRSP withdrawals in retirement.  This is another discussion.  We’re comparing your RRSP withdrawal tax rate today T to the tax rate you’d pay in the future on a larger RRSP withdrawal U.

The problem with trying to draw a conclusion at this point is that we haven’t considered all factors.  Everything else isn’t equal.  At the very least, you endured a lower lifestyle initially in scenario 2.  More likely, you spent the same in both scenarios, and your other accounts have different balances.

Suppose you’re wealthy enough that your TFSA is maxed out.  In this case, your non-registered account will have a higher balance in scenario 1 initially.  The extra M(1-T) will grow over the decade, but taxes will make it grow by less than a factor of R, and so you’ll have less than MR(1-T) in a decade.  In this case, if the present and future tax rates on RRSP withdrawals are equal (T=U), scenario 2 is better; deferring RRSP withdrawals has value.  If the future tax rate U is higher than the current tax rate T (due to the fact that the future RRSP withdrawal is larger), then it’s less clear which scenario is better.  We’d need some actual numbers to tell if the tax advantage is enough to overcome the RRSP deferral advantage.

But suppose your TFSA isn’t maxed out.  In this case the extra M(1-T) in your TFSA will grow tax-free to MR(1-T) in a decade.  The RRSP deferral has no value if the tax rates T and U are equal.  If your future tax rate on a larger withdrawal U is higher than the present tax rate T, then scenario 1 is better.

In a more realistic version of this analysis, you need to create a range of scenarios using your preferred spending pattern to find the best RRSP withdrawal timing.  In my case, the future RRSP withdrawal tax rate is higher when the withdrawals are larger.  This effect overcomes the advantage of continued tax-free growth, even though I have non-registered accounts.  I’m best off making modest RRSP withdrawals today, even though I don’t need the money for cash flow.  But your mileage may vary.