Don’t Neglect your RRSP

With the RRSP (Registered Retirement Savings Plan) deadline of March 1, 2021, just a week or so away, here are some RRSP stats, and the reason that RRSPs may win when compared to TFSAs and non-registered investing.

In 2020, Statistics Canada reported that Canadians held a total of $1.4 trillion in RRSPs, RRIFs and locked-in plans. It also reported that in 2018, of the 27.4 million Canadians that filed a personal income tax return, just over six million of them reported having made an RRSP contribution. Nearly one-quarter of those that contributed were aged 35 to 44 and the median employment income of a contributor was $64,660. In total, over $43 billion of new money was contributed in 2018, with the median RRSP contribution being $3,130 (2018 represents the most recent information available).

We dug a little deeper by using the Canada Revenue Agency’s income statistics for the 2017 tax year, and we were able to learn that of the almost 19 million tax filers who reported income under $50,000, approximately nine percent (approximately 1.7 million people) claimed an RRSP deduction that year. As income grows higher, however, the percentage of Canadians who claimed an RRSP deduction was significantly larger. For the highest income-earners, whose income was over $100,000 (representing 2.7 million Canadians), almost 60% of them claimed an RRSP deduction on their returns.

Now, if you’re new to the world of RRSP’s let us break it down for you:

• An RRSP is a tax deferral program allowing you to grow your retirement savings and defer the income taxes on the income earned.
• To entice taxpayers to save for their retirement, the government provides a tax deduction for amounts contributed to your RRSP.
• Annual contribution limits are based on your prior year’s earned income.
• Unused contribution room can be carried forward to future years.
• Withdrawals from the RRSP are taxed at your marginal rate.

To claim a deduction on your 2020 income tax return, you need to make a contribution by March 1, 2021, and the maximum amount you can contribute can be found at the very bottom of your “RRSP deduction limit statement” on your Notice of Assessment. You are also able to find it online by using the CRA’s My Account.

But what about the TFSA or even a non-registered account? Why might someone choose one over another?  There is no simple answer.  Like most questions about income tax, the answer is… It depends.

• As mentioned above, the RRSP provides a tax deduction in the year of a contribution and there is no income tax on income earned inside the RRSP, but as funds are withdrawn, they are taxable as ordinary income.
• A TFSA contribution does not give the contributor a tax deduction for any contributions however, similar to the RRSP, income earned inside the TFSA is tax-free. Withdrawals from the TFSA are also tax-free.  The annual contribution limit is set by the Department of Finance and is currently $6,000, much lower than the RRSP limit.
• A non-registered account (also known as a taxable account) does not provide a tax deduction when contributions are made, all income earned is taxable though tax rates on Canadian dividends and capital gains are at a lower rate than ordinary income, and after taxes are paid on the income or gains, the withdrawals are tax-free.

There are many other attributes to each account, and it’s important to consider those before making any decisions.  Often multiple accounts are used in conjunction with each other.

Here is an example to show you some of the differences:

Meet Kira, an Alberta resident, who earns $80,000 annually and contributes $3,000 of her employment income to an RRSP. Her marginal tax rate is 30.5% today and she is expected to be in the same tax bracket when the RRSP funds are accessed in retirement.

If on Jan. 2, 2021, she invested in a Canadian dividend-paying stock that had a five percent dividend yield, by the end of the year, her RRSP would be worth $3,150, assuming no stock appreciation. If she were to then cash in her RRSP, she would net $2,190 ($3,150 less tax at 30.5%).

Now suppose, instead, Kira preferred not to go the RRSP route and invested $3,000 of her employment earnings in the same 5% Canadian dividend-paying stock in a non-registered account, hoping to enjoy the preferred tax rate on those Canadian dividends rather than have them taxed as ordinary income when withdrawn from her RRSP. But, to save $3,000 of her employment income in a non-registered account, she would first have to pay a tax of $915 ($3,000 x 30.5%) on that income before investing the net amount of $2,085. The dividend yield of five percent would result in 2021 dividends payable to her of $105 ($2,085 X 5%). If we again assume no capital appreciation, at the end of the year, Kira will have $2,085 from her investment and $105 of dividend income on which she would pay combined federal/Alberta tax of approximately $11 owing to the dividend tax credit. So, after taxes are paid, Kira would net $2,179 (i.e., $2,085 + $105 – $11).

Her third option is to use her TFSA.  Like the non-registered account, there is no tax deduction for contributions and so she would start with $2,085 and earn the same $105 in dividends.  At the end of the year, Kira would have $2,190 in her TFSA.  As there are no taxes on withdrawals, she could withdraw the full $2,190 and not pay any income taxes.

So, which one is the winner?

With the results so close the answer is not simple.  As stated above, “it depends”.

Remember Kira’s income; it was $80,000. She is only saving $3,000 per year or 3.75% of her income.  Conventional wisdom would suggest that she should try to save 10% of her income or $8,000 per year to have a comfortable retirement. Currently, the TFSA account comes with a maximum contribution limit of $6,000. If Kira were to increase her savings to $8,000 per year, her TFSA alone would not be enough.

The above example also only assumes 1 year. After 5 years, the after-tax cash of the RRSP and TFSA are still virtually equal but the gap between these two and the non-registered account is much larger which likely pushes the non-registered account to 3^rd place.

Finally, the example above assumed that the tax rate during Kira’s earning years and retirement (withdrawal) years is the same. In an ideal situation, her tax rate during retirement would decline and she would realize tax savings as well. If Kira was to retire after 5 years in the above example, and her tax rate was to decrease to 25%, her RRSP would be worth about 8% more than her TFSA in after-tax funds.

So, while there is no “one-size-fits-all” answer, an RRSP can be a more effective method of saving for retirement than the TFSA.

Still not sure what to do? Our wealth planner can put together a comprehensive wealth plan for you and help break down different scenarios and options. And, with the benefit of the integration we have with KBH Chartered Professional Accountants, your tax and estate planning can be considered giving you a more holistic view into your financial future.