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Does the mini-budget make RRSPs obsolete?
Key is putting tax savings to work

October 18, 2000 marked an important day for Canadian taxpayers. Paul Martin, Canada's Finance Minister, delivered a speech detailing several initiatives that included paying down the debt, to cutting taxes. A couple of items that interested most investors were the accelerated reduction of the tax brackets and the cut in capital gains taxes. With lower taxes overall and still lower taxes on capital gains, many have begun to wonder if this now tips the scales away from the RRSP as a retirement wealth-building tool of choice. While this isn't a core investment topic, this issue largely impacts the development of investment policies, whether you do it yourself or with your advisor.

RRSP Benefits and Proposed Tax Changes

It may be helpful to first review the key benefits of making RRSP contributions.
  1. Contributions into the RRSP are tax deductible at the current marginal tax rate.
  2. The entire RRSP grows on a tax deferred basis, until withdrawals begin.
  3. When withdrawals are made, they are usually during retirement at a lower marginal tax rate.
While the recent budget did not address RRSPs directly in any way, the proposed measures work to make RRSP contributions less effective. In short, tax rates were reduced across the board. At the beginning of this year, just 3/4 of all capital gains were taxable. (The 3/4 figure is commonly referred to as the capital gains inclusion rate.) February's budget reduced that to 2/3. As of October 18, 2000 the inclusion rate fell again to 1/2 - the same rate that applied prior to 1986. That puts the highest marginal tax rate (i.e. the rate applied to each additional dollar of taxable income) for capital gains at no more than 25 per cent across the country.

The million dollar question is: what impact do these recent tax proposals have on the merits of making RRSP contributions?

Recent Research

Few industry professionals have been able to make concrete conclusions on, or quantify the relative merits of, contributing to a RRSP versus putting that same cash to work elsewhere (i.e. mortgage or non-RRSP investment). Innovative research by Talbot Stevens concluded that the RRSP is usually the best choice for Canadians, but not always. Stevens' analysis focussed on which avenue produced the most after-tax income during retirement - a method that makes a lot of sense. Two months ago, my research into this issue uncovered similar findings. My conclusions are summarized below:

  • Ultra-conservative investors are better off saving inside RRSP plans.

    Conservative investors are those that hold primarily GICs (guaranteed investment certificates) in their portfolios. Despite falling tax rates, interest income remains fully taxable - still painful especially at higher tax rates. The benefit of receiving a deduction and deferring all of the interest income is a huge benefit to those that fall into this category.

  • Individuals in the lower tax bracket (i.e. taxable income under $30,000) usually benefit more from using excess cash flow to invest outside the RRSP and/or to reduce mortgage principal.

    Those in this tax bracket still benefit greatly from Canadian-source dividend income, which is taxed at just over 6 per cent, instead of interest which is taxed at the full marginal rate of 23 per cent. However, if growth is the objective, investments which produce mainly deferred growth (i.e. stocks or stock mutual funds) will provide the greatest benefit, despite a lower retention rate than dividends in this tax bracket. Of course, paying down a mortgage is never a bad move, especially in this tax bracket, because it's a low risk alternative.

  • Those who position non-RRSP investments more aggressively may benefit more from investing outside of the RRSP

    Due to foreign content limits and the desire to keep interest-generating investments sheltered, many investors focus their non-RRSP savings, if any, on investments with higher growth potential. Since these would be equity-based investments which defer most of the growth, this can often prove to be a more beneficial choice for Canadian investors.

    The Behavioural Factor

    Recall from above that contributing to a RRSP always results in some immediate tax savings - depending on your income level. Notwithstanding the above generalizations, the key to this decision has always rested in Canadians' ability to put those tax savings to work. My initial research concluded that Canadians had to use at least 25 per cent of the tax savings from RRSP contributions, to make them a worthwhile option. As with investing in general, the most important determinant of success is the behaviour of the individual. With investments, that means not chasing the hottest new sector and not selling at low points. With wealth-building strategies it means having the discipline to keep tax savings earmarked for uses that enhance long-term wealth.

    Of course not everybody will be able to make use of their tax savings. For instance, many self-employed individuals simply reduce an already substantial tax bill by contributing to a RRSP. In that case, there is no real cash flow coming back to the investor for use elsewhere. Hence, the RRSP option should usually be avoided. For clarity, let's look at this in a numerical context.

    Consider an individual with between $40,000 and $60,000 in taxable income; 20 years until retirement; and earning a gross return of 7 per cent annually on all investments before and after retirement. Let's first assume that this individual cannot make use of any of the tax savings. In this case, saving for retirement outside of the RRSP will result in an after-tax retirement income level that is 4 per cent higher than that generated by using the RRSP as the primary retirement savings vehicle. Put another way, the after-tax return of the RRSP in this example is 6.39 per cent per year, compared to 6.54 per cent for the non-RRSP option. Though the numbers differ somewhat, the overall conclusion is consistent across all income ranges.

    If we take that same individual and now assume that half of the tax savings from RRSP contributions can be invested elsewhere, we have a very different outcome. The optimal choice now is to contribute to the RRSP and invest half of the tax savings. The after-tax return is equal to 7 per cent annually, while after-tax income during retirement is more than 18 per cent higher compared to contributing to the RRSP and not reinvesting any tax savings.

    Again, across various income levels and tax rates, the numbers change somewhat but the conclusion is consistent throughout. The higher the tax rate the larger the impact of tax savings reinvestments.

    Reducing taxes somewhat diminishes each of the three aforementioned RRSP benefits. The reduction of general tax rates means the immediate tax deduction of contributing to a RRSP becomes smaller starting next year. The long-term tax deferral benefit is also reduced since the taxes that are being deferred have fallen. Finally, as tax rates fall, the gap between the tax rate in force when the deduction is granted and the tax rate applied to withdrawals narrows.

    While that might sounds like a case for ditching your RRSP plans, it's not. I found that even when very close to retirement (i.e. one to five years), the same rules apply - the key is what people do with the tax savings. If you can't use any of the tax savings, don't be afraid of challenging conventional wisdom and think twice before contributing to a RRSP.

    For more details on the mini-budget, see this article in the National Post by Jonathan Chevreau or visit one of Canada's big accounting firms:

  • KPMG
  • Deloitte and Touche
  • Ernst and Young
  • Arthur Andersen
  • PricewaterhouseCoopers

    Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
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