Strategic RRSP Planning

In this article aimed at Canadian readers, I briefly explain what a Registered Retirement Savings Plans (RRSP's) is, and the strategic principles of why you would want to use them. My discussion is aimed at readers who are relatively far away from retirement. (There are similar savings vehicles in other countries which may have similar principles, but the details depend upon the specifics of tax laws.) I discuss why arguments that RRSP's will face tax disadvantages because "governments are broke" are questionable.

What Is A RRSP?

An RRSP is a type of account that allows you to hold investments, but it is not an investment by itself. You cannot "buy an RRSP", for example.

The key point to understand about an RRSP is that they allow you to defer taxes on income - you will pay taxes on the income, but in a later tax year. The idea is that this withdrawal should be at a lower tax rate, as you should generally expect to have a lower income in retirement than when you are working (after taking inflation into account).

Assets you hold within the RRSP grow without incurring taxes. This reduces bookkeeping, and means that RRSP's should compound much faster than investment accounts that are not sheltered from tax.

You have a RRSP contribution limit, which is sent to you by the Canada Revenue Agency in your Notice of Assessment (sent after you have filled in your taxes). If you have no other pension plan, your limit will be 18% of the previous year's earned income (e.g., wage income, but not investment income), to a maximum level (which was $23,820 in 2013). If you have a pension plan at work, your contribution room is lowered by a pension adjustment, based on the value of contributions. For example, if your pension plan is fairly extensive, you may have almost no RRSP contribution room left over.

If you have a lot of RRSP room and you want to handle your own investments, it is probably best to put your RRSP investments into a self-directed RRSP. A self-directed RRSP is similar to any other brokerage account, although you have some limitations on your investments (you cannot use margin debt, for example). This is balanced against the possibility that you may have to pay a fee to have a self-directed account if the account size is below a certain size. Otherwise, you will probably end up placing your money in mutual funds, but you should not have to pay a fee.

I do not want to cover all of the details of what an RRSP is within this article, so I would recommend another source - such as the KPMG tax guide that I reviewed earlier - for more details. Instead, I want to write more about the strategic aspects. This article is aimed at someone who is at least a decade away from retirement, and should not need to withdraw funds from the RRSP in the near term. Someone who is closer to retirement will have to think about the mechanics of withdrawing funds, and the tax implications of doing so. For such people, dealing with a RRSP is much more tactical, as you are looking at relatively short-term tax planning.

The Value Of Deferring Tax

Income taxes are progressive: you pay a higher percentage of taxes the more you earn. The chart above shows the combined federal and provincial tax rates faced by residents of Manitoba. (I have chosen Manitoba as the tax situation in my home province of Québec is somewhat complicated, and I wanted a province with a higher tax rate.) The chart shows two lines:

1. The average tax rate is the black line, and is the amount of taxes you pay divided by your total income. For example, at $100,000 the average tax rate is (about) 30.5%, meaning you pay about $30,500 in tax. 
2. The marginal tax rate is the red line, and is the amount of tax you pay on each additional dollar you earn. For example, with a $100,000 income, 43.4 cents out of every additional dollar you earn is taxed away.

Note that the tax calculations I use ignore any other factors that adjust the tax bill, other than the basic personal credit which has the effect that the first $9,000 (roughly) you earn is free of tax. Please note that I am not a tax professional, and it may be that my calculated tax rates may be missing some important factors. (I am basing them off tables from the KPMG book I referred to earlier.) That said, the strategic principles are not changed even if I my numbers are slightly off.

The key point to note is that the marginal tax rate is always higher than the average tax rate, unless your income is below the lower threshold for paying income tax.

It is now possible to see the advantage of an RRSP - the money you contribute to an RRSP is subtracted from your taxable income. It is thus removing income from being taxable at the highest marginal rate you face.

For example, assume that you lived in Manitoba and your income was a nice round $100,000, and you had no other factors affecting your taxes. Your taxes would be $30,530.

If you contribute $18,000 to an RRSP, your taxable income drops to $82,000, and your income tax bill drops to $22,923.

This means you save $7607 in taxes, which is 42.3% of the RRSP contribution. This is the average marginal rate over the interval $82,000 - $100,000 (which are marked by vertical lines on the charts). Your tax savings as a percentage of the contribution is going to be close to the marginal rate on your total income.

But you will have to sell the assets within your assets and withdraw them from your RRSP at some point. These withdrawals are taxable income.

We will now assume that you are withdrawing enough from your RRSP to match what you had available after RRSP contributions when you working. In this case, assume that you withdrew $82,000 from your RRSP. The total tax paid on that withdrawal would be about $22,900 or 28% of $82,000. If you withdraw money from your RRSP and you have no other income, it is taxed at your average tax rate.

In this case, you get a tax rebate at a rate of 42.3% when you contribute (the red line in the chart), but only pay an average tax rate of 28% (the black line).

Complication - Clawbacks

One thing that has to be kept in mind is that you face "clawbacks" of social benefits in retirement if you have a high income (please see a tax planning book for details). For example, the Old Age Supplement may be taxed back if your income is high enough. This means that the effective tax rate is higher than what is suggested by my simplistic calculations above.

This should figure into your planning when you are already retired, or are close to retirement (less than 10 years). But let's face it, if you are worrying about a too high income in retirement, that's a problem that a lot of Canadians would wish they have. But if you are far away from retirement, this factor should not be weighed too heavily. You should not be concerned about scenarios where you are otherwise doing well, you should worry about scenarios where you are doing poorly. And if you do end up with a low income in retirement, you will not face clawbacks nor a high tax rate when you withdraw the money (see discussion below). In which case, the RRSP offers very considerable tax savings.

Complication - Uneven Income During Working Years

If you have a low income year, it is probably worthwhile not making a RRSP deduction in that year. Instead, deduct the contribution in a year where your income has bounced back (and will face a higher marginal tax rate).

If you have almost no income, it may be worthwhile to withdraw some money from your RRSP - you do not have to wait to retirement. If your income is below the threshold, you may end up paying no tax. But since such a withdrawal means you have lost the ability for RRSP assets to grow on a tax-sheltered basis, making a withdrawal may not be a good idea if you are young. Losing 20 or more years of tax-sheltered growth may be more costly than the immediate tax savings.

Complication - Inflation

Personal financial planning is complicated by the fact that if you want to do it properly, you need to forecast variables like inflation and tax rates for decades. If you are young, you should expect to be earning much higher dollar amounts when you are older, just based on inflation. If tax brackets are unchanged, this would mean that the same inflation-adjusted income will end up paying higher taxes.

I would argue that the base case scenario should be that tax brackets will rise roughly in line with inflation. In other words, if your salary just keeps pace with inflation over the years, you should face about the same tax rate. The implication is that when I do my financial plan, I project the current situation forward indefinitely, with the assumption that all amounts are rising by the rate of inflation. (When looking at asset returns, that means that you need to deduct the rate of inflation from their returns.)

Complication - Will Tax Rates Rise?

One complaint about RRSP's is that governments are allegedly "broke", and that tax rates will inevitably rise.

This is a topic of discussion on my main web site (bondeconomics.com). I am in the camp that is makes no sense to think of a government that can create the currency in which it borrows as being "broke". But even so, tax rates will not have to rise forever and ever, they would only need to rise during the peak years of the baby boom retirement. Unless some medical miracle arrives soon, the number of retirees relative to the number of people working will start falling after about 20 years or so. Any tax hikes related to demographics should begin to be reversed at that point, as the strain on the welfare system would fade.

• If you are about 55-65, you are in the "baby boom" demographic that would face higher tax rates in retirement. But you have already made most of your contributions to your RRSP, and so it is too late to anything about it. If you actually want to worry about demographic macroeconomic scenarios, you might consider front-loading your RRSP withdrawals. (This may also help deal with clawbacks.)
• If you are younger than 45, you have no reason to care. You will be making your RRSP contributions during the period when taxes are allegedly going to rise, and you will withdrawing them in your retirement, when the bulk of the baby boomers have passed away and average tax rates should be lower.

In any event, the existing gap between marginal and average tax rates is large. Income tax rates would have to rise a lot in order for the average tax rate for withdrawals to match the marginal tax rate faced by contributions.

Of course, tax rates could rise for other reasons. It is possible that the political shift to the right that we have seen over the past 30 years may reverse, and the size of governments could once again start to increase. It is highly unlikely that anyone could accurately forecast such a shift, and so I would not build retirement financial plans around such a scenario.

(c) Brian Romanchuk 2014