My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant and a partner with a National Accounting Firm in Toronto. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. The views and opinions expressed in this blog are written solely in my personal capacity and cannot be attributed to the accounting firm with which I am affiliated. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned.

Thursday, January 27, 2011

The RRSP Hullabaloo

There has been a sudden surge of angst in the media recently in regard to; whether you should contribute to your RRSP or TFSA, whether the mandatory minimum yearly withdrawals from your RRIF are too high, and finally, how higher tax rates in the future could affect your RRIF at the time of withdrawals.

I just don’t get this angst. High income earners are already contributing to both their RRSP and their TFSA. They are tax neutral at worst in their RRSP’s as they get a refund on their RRSP at the highest marginal rate of 46.41% and currently pay tax on RRIF withdrawals at 46.41%.

Low income earners are not making RRSP contributions, so unfortunately, they are not part of any argument. So, who does this discussion impact? Maybe the lower middle class, the middle class and the upper middle class.

At this point I want to clarify that if your current marginal income tax rate is equal to or higher then your anticipated marginal tax rate at retirement, you can’t be worse off RRSP wise, subject to inflation and increases in the marginal tax rates. I would suggest that for most people, their marginal rate will be lower at retirement.

In response to a blog along those lines by Larry Macdonald (click here to see Larry’s excellent blog), I wrote the following (I have amended this slightly from my response to Larry):

Let’s say Andrea makes between $80,000 to a $120,000 in his peak earning years of 45-65. I would say Andrea is upper middle class with his earnings. During those years he contributes on average $10,000 to his RRSP and let’s say the RRSP grows at 6%. Finally, let’s say that from age 65 until age 71, Andrea and his wife Barbani fund their retirement and Raptor tickets by living off other savings and an inheritance and do not encroach on his RRSP until age 71.

Andrea’s RRSP contributions from age 45-65 would have grown to approximately $350,000 at age 65, give or take a few bucks, and would further grow to $500,000 by age 71 when he has to convert his RRSP to a RRIF. His minimum RRIF withdrawals would be almost $40k or so at 71, dropping down to the lower $30’s as he ages.

Assume Andrea and Barbani’s CPP and OAS is $30k combined (probably typical for a family with a wife who worked, but had some years off to raise the kids).

Thus, the family will have around $70k a year in taxable retirement income. Assuming today’s marginal tax rates and using split pension amounts to share the tax hit, each spouse would pay income tax of around $4,000 or 11% after taking into account the age and pension amounts.

During the years Andrea earns $80k to $120k he saved 40-46% for each RRSP contribution and at retirement he is only paying 11%. For what I would consider not far off the typical Canadian living in a large city, I see no argument against the use of a RRSP. Of course inflation would factor into this calculation. However, the point of the above exercise is to reflect the 30% or so difference in Andrea’s current marginal rate and the low rate he and his wife would incur at retirement.

In regard to the TFSA argument, in the above example, $10,000 contributed to a RRSP nets a refund of approximately $4,600 and the tax on the cash coming out of the RRIF is $1,100 per $10,000 (11% on $10,000). Thus, the net after-tax cash flow is $13,500 ($10,000 original RRSP contribution + $4,600 original refund less $1,100 income tax) far in excess of the $10,000 you could alternatively put in your TFSA. 

The above is obviously very oversimplified to make a point. I did not account for the tax free growth in the RRIF and TFSA and the fact the tax-free growth in the RRSP is taxed and the tax-free growth in the TFSA is not. However, if you put the $4,600 refund from your RRSP into your TFSA, you would still be substantially better off with the RRSP, due to the low rate of income tax upon the withdrawal of your RRIF, even though all the growth of the TFSA is tax-free.  

There are various factors that could change the above results. Tax rates can increase over time, inflation can rear its ugly head  and where one spouse dies, the surviving spouse could get caught up in higher tax rates and the income splitting benefit stops with the passing of the other spouse.

All in all, I just don’t see the cause for angst around this topic. 

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.