Do RRSPs still make sense?
Add RRSPs to the list of conspiracy theories to be on the lookout for - which means it may be time for a refresher on what RRSPs really do for you.
I'm amazed at how often I'm engaged on the issue of whether RRSPs "still make sense". Somehow, it seems, a modern legend has formed and circulated about how RRSPs aren't really good for you anymore, and that you should eschew or strip them.
The line of discussion often has a conspiracy-theory vibe, where the suggestion is that RRSPs are some sort of trap, and avoiding them is how you can stick it to The Man. In fact, in its most aggressive form, the advice that comes along with this involves schemes that will allow you to get the money out of your RRSP on a tax-free basis.
Well, be assured that you're not missing any special new development in financial planning. Registered Retirement Savings Plans remain a cornerstone of retirement planning for most Canadians who do not have a pension plan. And those tax-free withdrawal schemes are such a bad idea that the Canada Revenue Agency has posted a warning on its website. Given that much of success involves being brilliant at the basics, let's just review the deal we get with RRSPs. Yeah, sure, you learned this already. But given the misinformation out there, a refresher may be in order.There are two significant benefits to having an RRSP. The first is that the money you contribute to your RRSP is deductible from your taxes. That means that you get to save from your gross pre-tax income instead of from your net income. And that's a wildly important point.Let's say you make $50,000 a year, and you want to maximize your allowable RRSP contribution. The RRSP rules say that you're allowed to contribute up to 18 percent of your taxable income (subject to a cap of $19,000 for 2007, and $20,000 for 2008). So your $50,000 income makes you eligible to pop $9,000 in your RRSP. Now, because you get to deduct that contribution from your income, you won't pay income taxes on the last $9,000 of the $50,000 you made. And since that last $9,000 of income would have been subject to about 31 percent in combined federal and provincial income taxes (in B.C. - it's even higher in the other provinces), the opportunity cost of putting $9,000 in your RRSP is only about $6,200.So there's the first benefit of an RRSP. It costs you exactly the same amount to save $9,000 inside an RRSP as it does to save $6,200 in a regular investment account. So far, so good. But wait, there's more.The second benefit of an RRSP is that any investment income earned inside the plan won't attract any immediate taxation. If you invested $6,200 outside of an RRSP, you'd have to pay taxes on any interest income or realized capital gains. So that four percent bond interest would earn less than three percent after tax. And even though the tax rate charged on capital gains is only half of your regular rate, that's still a fifteen percent haircut on your growth rate.Now, let's put those two benefits together, and compare them to the alternative of saving outside an RRSP. Let's assume that you're a growth-oriented investor, and that you're going to hold 30 percent of your portfolio in bonds, and 70 percent in stocks. Let's also assume that the bonds will average an annual return of four percent interest income, and the stocks will average ten percent as capital gains. Over the next twenty years, will you be better off saving $6,200 outside an RRSP, or $9,000 inside an RRSP? I'll do the math for you. In this example, the regular investment account ends up with $248,000. And the RRSP ends up with $421,000.Ah, but wait! You have cleverly detected that we're not comparing apples to apples here. The regular investment account has no additional tax liability hanging over it, and the money in the RRSP will all be taxed when it comes out as income. Well, that's absolutely true. But in this case, the money coming out of the RRSP would all have to be taxed at 41 percent just to make this an even deal. And if your retirement nest egg is $421,000 plus government benefits, you simply don't end up in a 41 percent tax bracket.Of course, your income, time horizon, province, and risk tolerance may well all vary from the above pat example. And that would change the numbers.If the income and tax brackets are higher, for instance, the RRSP looks even better. If the time period is longer, the RRSP looks even better. If your province taxes more punitively than B.C. (and, mostly, they all do) the RRSP looks even better. And if the return is higher, well, the RRSP looks better then too.Sure, it's possible to contrive a model where the RRSP isn't the king, so you should always consider your specific case. But generally speaking, the question of whether to use an RRSP to save for retirement remains, as ever, a no-brainer.
© 2008 John Caspar
John Caspar, CFP, FMA, FCSI is a Vice President and a Financial Advisor with Raymond James Ltd. The views of the author do not necessarily reflect those of Raymond James. This article is for information only. Raymond James Ltd. is a member of CIPF. John's web page is www.johncaspar.com