Different Ways of Comparing RRSPs to Other Types of Accounts
I’ve had some reader feedback about my recent post on debunking RRSP myths concerning realistic approaches to making RRSP contributions. Here I take a look at different ways to fairly compare RRSPs, TFSAs, and non-registered accounts.
In the original post, my hypothetical investor, Ami, only had $6000 available to invest for the long term, but knowing that she was in a 40% marginal tax bracket, she made a $10,000 RRSP contribution and counted on the $4000 tax refund. Some readers think it’s more realistic to assume that Ami would only make a $6000 RRSP contribution, which is fair enough.
However, the $2400 tax refund that Ami gets from the $6000 RRSP contribution has to play a role in comparing this RRSP approach to investing the $6000 in either a TFSA or a non-registered account.
With one way of handling the income tax refund, we could just assume that Ami puts it into her RRSP as well. But that’s not the end of it. Ami’s $2400 contribution next year generates a $960 refund the following year. When that amount goes into the RRSP, Ami gets another refund of $384 a year later. And on it goes with ever smaller RRSP contributions and refunds year after year. If you add up all the contributions until the end of time, it will add up to $10,000.
Of course, Ami may find that she needs to spend the $2400 tax refund and doesn’t make an RRSP contribution the next year. In this case, she won’t contribute more than the original $6000 to her RRSP. If this is the case, then we need to amend the TSFA case to account for her spending needs. If Ami put the original $6000 in a TFSA and then needed $2400 the next year, she will have to make a withdrawal from the TFSA.
In this TFSA case, we’re comparing a single $6000 RRSP contribution to a $6000 TFSA contribution, followed by a $2400 withdrawal from the TFSA the next year. So, the TFSA has a slight advantage over the RRSP of one year of returns on $2400. A non-registered account would have the same small advantage over an RRSP, but the tax drag on the non-registered account would be much higher than this small advantage.
No matter what reasonable assumptions you make to get an apples-to-apples comparison, RRSPs and TFSAs give about the same results when tax rates are constant, and both are better than a non-registered account.
Of course, irrational behaviour on Ami’s part could change everything. If Ami always wastes tax refunds on things she definitely would not have bought anyway, then RRSPs won’t work well. If she leaves RRSP savings alone but dips into her TFSA or non-registered account for wasteful spending, then RRSPs look best.
If we go back to a mostly rational Ami, changing tax rates from when Ami is saving to when she retires is what dictates whether RRSPs or TFSAs are better. And non-registered accounts are almost never a better choice for long-term savings than whichever is better between an RRSP and a TFSA.
In the original post, my hypothetical investor, Ami, only had $6000 available to invest for the long term, but knowing that she was in a 40% marginal tax bracket, she made a $10,000 RRSP contribution and counted on the $4000 tax refund. Some readers think it’s more realistic to assume that Ami would only make a $6000 RRSP contribution, which is fair enough.
However, the $2400 tax refund that Ami gets from the $6000 RRSP contribution has to play a role in comparing this RRSP approach to investing the $6000 in either a TFSA or a non-registered account.
With one way of handling the income tax refund, we could just assume that Ami puts it into her RRSP as well. But that’s not the end of it. Ami’s $2400 contribution next year generates a $960 refund the following year. When that amount goes into the RRSP, Ami gets another refund of $384 a year later. And on it goes with ever smaller RRSP contributions and refunds year after year. If you add up all the contributions until the end of time, it will add up to $10,000.
Of course, Ami may find that she needs to spend the $2400 tax refund and doesn’t make an RRSP contribution the next year. In this case, she won’t contribute more than the original $6000 to her RRSP. If this is the case, then we need to amend the TSFA case to account for her spending needs. If Ami put the original $6000 in a TFSA and then needed $2400 the next year, she will have to make a withdrawal from the TFSA.
In this TFSA case, we’re comparing a single $6000 RRSP contribution to a $6000 TFSA contribution, followed by a $2400 withdrawal from the TFSA the next year. So, the TFSA has a slight advantage over the RRSP of one year of returns on $2400. A non-registered account would have the same small advantage over an RRSP, but the tax drag on the non-registered account would be much higher than this small advantage.
No matter what reasonable assumptions you make to get an apples-to-apples comparison, RRSPs and TFSAs give about the same results when tax rates are constant, and both are better than a non-registered account.
Of course, irrational behaviour on Ami’s part could change everything. If Ami always wastes tax refunds on things she definitely would not have bought anyway, then RRSPs won’t work well. If she leaves RRSP savings alone but dips into her TFSA or non-registered account for wasteful spending, then RRSPs look best.
If we go back to a mostly rational Ami, changing tax rates from when Ami is saving to when she retires is what dictates whether RRSPs or TFSAs are better. And non-registered accounts are almost never a better choice for long-term savings than whichever is better between an RRSP and a TFSA.
Can you come up with any scenarios where a non-registered account works out better than an RRSP even with withdrawals taxed at a lower rate than contributions? Understanding how that can happen might help put the question to rest.
ReplyDelete@Richard: I don't see how this question is central to the debate over what size of RRSP contribution should be compared to a $6000 TFSA contribution. But focusing on your question, I can't think of any scenario that fits your description. There certainly are scenarios that fit if withdrawals are taxed at a higher rate than contributions.
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