Case Study: The Power of an RRSP - Ali's Story

Ali's co-workers don’t like RRSPs. They know that money contributed to an RRSP today creates a tax refund—the money is effectively not taxed and investment income generated in the RRSP is tax-sheltered. The part they don’t like is what happens when the money is withdrawn. They asked, “What is the point of having an RRSP if you just have to pay tax on the money as you withdraw it?”

Ali's Question

Will I accumulate more money inside an RRSP than simply saving and investing outside one?

The Analysis

It depends. Tax is a major consideration when analyzing whether or not an RRSP is a good savings vehicle. The higher Ali’s marginal tax rate (MTR), the higher his RRSP tax refund. The RRSP benefit is further enhanced as the spread between his tax rate today and his tax rate when withdrawing his money widens.

Ali decides to run a test before receiving this year’s bonus of $20,000. He analyzes what will happen if he splits the money by investing half in an RRSP and the other half outside it (no one has told him about using a TFSA). Ali inputs his 40% marginal tax bracket (for inside the RRSP) and assumes he’ll earn a 5% investment return with either investment method. He further assumes the worse case scenario by applying his MTR to the non-registered investment returns (outside the RRSP).

 

Outside the RRSP

Inside the RRSP

Bonus: Before-tax

$10,000.00

$10,000.00

Less tax at 40%

($4,000.00)

No tax, if transferred directly into RRSP

Bonus: After-tax

$6,000.00

$10,000.00

5% investment return

$300.00

$500.00

Less tax at 40%

($120.00)

($0.00)

Value after year 1

$6,180.00

$10,500.00

Short-Term RRSP Advantage

  • The $4,000 otherwise lost to tax is now available for investing.
  • The 5% earned on the full $10,000 is not taxed.

Long-Term Advantage

  • Every time Ali adds to his RRSP, he defers paying tax on the contributions and grows his money on a fully tax-sheltered basis.
  • Over 20-30 years, the growth inside the RRSP will be considerably more than could be achieved outside the RRSP.
  • The lower his tax rate at withdrawal, the more he will save. If his withdrawals are taxed at 30%, he pays 10% less tax than he would have paid when he made the original contribution.

Disadvantage

If Ali was in a 25% tax bracket, his tax savings would only be $2,500, not $4,000. There is a risk he might be in the same, or possibly even a higher, tax bracket when he withdraws the money. For low-income earners, check out whether a TFSA may be a better choice than an RRSP.