Tax Rates on RRSP Contributions and Withdrawals

Recent Rational Reminder podcasts (319 and 321) have had a debate about tax rates on RRSP contributions and withdrawals.  Most people agree that when you contribute, you’re lowering your taxes at your marginal tax rate.  The debate concerns withdrawals.  Some say that RRSP withdrawals come at your “average, or effective tax rates, not your marginal tax rate.”  Here, I address this question.

With Canada’s progressive tax system, the first part of your income isn’t taxed at all (or is taxed negatively when you consider income-tested government benefits), then the next part of your income is lightly taxed, and marginal tax rates increase from there as your income rises.

A question that comes up in my own portfolio accumulation and decumulation planning is what order to stack income each year.  Is it CPP and OAS that are taxed lightly and RRSP withdrawals taxed more, or should I stack the income in some other order?  What about other income from non-registered savings?  Maybe everything should be assigned the same average tax rate.

The truth is that this is only a struggle because we’re trying to assign tax rates to one strategy in isolation.  Whether a strategy is good or not cannot be decided in isolation.  It only makes sense to compare two or more strategies.  When we compare strategies, it becomes obvious how to handle tax rates.

Let’s try to create two strategies that isolate the RRSP as the only difference.  Strategy 1: no RRSP.  This strategy might include TFSA contributions or other elements, but it does not use RRSPs.  Strategy 2: everything from strategy 1 plus RRSP contributions while working, and RRSP withdrawals after retiring.

Comparing the two strategies during working years, we should think of RRSP deductions as coming off the highest part of the total income because that is the difference between the two strategies.  If we apply the deduction somewhere in the bottom or middle of the income range, then the other income (that is the same in both strategies) will be taxed differently in the two strategies.  We want to find the net difference between strategies, and that comes from treating the RRSP deduction as coming at the marginal tax rate.

During retirement years, we end up with a similar argument.  Both strategies will have the same income each year, except that Strategy 2 will have additional RRSP withdrawal income.  To isolate the differences in income and taxes between the two strategies, we must think of the RRSP withdrawal as being the last, most highly taxed part of the income.  So, it’s taxed at the marginal rate.

At this point, we should comment on what we mean by marginal rate.  It is usually defined as the tax rate on the last dollar earned.  However, we usually aren’t discussing amounts as trivial as a single dollar.  Larger amounts can easily span multiple marginal tax brackets.  So, it’s possible for your RRSP deduction to give part of its tax savings at one rate and part at a lower rate.  

So, when we say that RRSP contribution tax savings occur at your marginal rate, this might actually be a blended rate, not to be confused with your overall average tax rate.  For example your marginal tax rate might be 43%, your tax savings rate on RRSP contributions might be partly 43% and partly 38% for a blended rate of 40%, and your average tax rate might be 25%.

This effect becomes larger for RRSP withdrawals, because the withdrawals tend to be larger than the contributions.  If your income consists of CPP, OAS, and RRSP withdrawals, your RRSP withdrawals may be the bulk of your income and may span multiple marginal tax brackets.  So, even though we say you pay tax on the RRSP withdrawals at your marginal tax rate, this is actually a blended rate that may not be too much higher than your average tax rate.

So, when comparing the strategies that differ only in RRSP contributions and withdrawals, the argument that RRSP withdrawals come at your average tax rate might be sort of true in the sense that they will likely be at a blended rate, but we get the correct answer when we think of RRSP deductions and income as coming at the top of your income.  We can only answer such questions properly when comparing two or more accumulation and decumulation strategies rather than analyzing one strategy in isolation.