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The RRSP Debate - Part II
RRSP is still clear winner for many

Last week, I wrote about how the Federal mini-budget made RRSPs a little less attractive for some individuals. However, my choice of words may have understated the continued attractiveness of RRSPs as a retirement planning tool. There was one underlying assumption in last week's numbers which is important to note and demands further examination.

The assumption: the identical amount of money is available for either RRSP or non-RRSP options.

In reality, that's not the case for many individuals. For those with the same amount of money to put towards either option, the tax savings remain key. Alternatively, if the immediate tax deduction on RRSP contributions is the only way you can afford to save money or if it allows you to contribute significantly more, the RRSP is usually the best choice.

The RRSP produces a lower amount of after-tax income during retirement because all amounts withdrawn are fully taxable at your prevailing tax rate, when compared to regular investments. Hence, when the identical amount of money is placed in each option, some of the tax savings must be reinvested elsewhere just to equate the generated after-tax income to that of a non-RRSP investment. Let's look at a situation where differing amounts are at stake.

Example

Steve's is in a 33 1/3% marginal tax bracket with an expected tax bill in April of $2,000. He has twenty years until retirement and has a total available cash flow of $6,000. This leaves two choices:

  • Pay the $2,000 tax bill and invest $4,000 elsewhere; or
  • Invest $6,000 in his RRSP, thereby wiping out his tax bill with no reinvestment of tax savings.

    Again, our focus is on a comparison of after-tax income. On a proportionate basis, it's easiest to express the income generated as a percentage of the initial contribution. In this scenario, every $10,000 investment generates $1,888 in annual after-tax retirement income. The RRSP, per $10,000 investment (and assuming no reinvestment of tax savings), generates $1,638 of annual after-tax retirement income. While the regular investment produces a higher proportionate amount of after-tax retirement income (18.88 per cent of the initial contribution vs. 16.38 per cent), the actual dollar amount is substantially less ($755 vs. $983) because less money is available for investment outside of the RRSP. In fact, contributing to a RRSP in this situation yields 30 per cent more in after-tax retirement income.

    If we take that same scenario but instead assume that retirement is only five or ten years away, the RRSP still provides an after-tax advantage over the non-RRSP option whether taken in the form of income or if fully redeemed - which may happen upon death. Hence, as retirement nears, the gap between the two options narrows gradually but remains significant and continues to support the benefits of using RRSPs as a retirement planning tool as late in the game as five years before retirement. Of course, this won't be the case where an individual's post-retirement tax bracket exceeds the pre-retirement tax bracket by a significant margin.

    Break-Even Point

    Since we've determined that having more to invest in a RRSP is more valuable than a lesser amount in a regular investment, how much more is needed up front in a RRSP to beat a regular investment? Returning to our example above, Steve has a maximum amount of total cash flow available ($6,000) to cover his tax bill and his retirement savings. In his case, a RRSP contribution of $4,610 would generate an equal dollar amount of after-tax retirement income as the regular investment of $4,000. Steve was in a 33 1/3% tax bracket, but what about lower income individuals.

    The lowest income bracket will be about 22 to 23 per cent. For simplicity, let's assume that Nancy is in the 23 per cent marginal bracket, has twenty years before retirement, has a total of $2,000 available for investment, and faces a tax bill of $460. Her two choices are:

  • pay the tax bill of $460 and invest the remaining $1,540 in a regular investment; or
  • contribute the entire $2,000 to a RRSP, thereby wiping out the entire tax bill.

    Using our proportions above for the twenty year time frame, we already know that a regular investment will produce a retirement income of 18.88 per cent of the initial contribution - or $291 on the $1,540 investment. The RRSP will generate $328 (or 16.38 per cent) from its $2,000 initial investment. The bottom line is that even in the lower tax bracket, the RRSP can still result in a retirement income that is about 13 per cent higher than using a regular investment.

    Conclusions

    This is a complex topic that requires a very personalized answer for each case. Investor behaviour can play a big part in evaluating which option is best but not all situations can be formulated into a spreadsheet. I doubt that the mini-budget made a huge difference in this decision, except to make the RRSP less attractive for some investors. While the rules of thumb mentioned last week don't apply across the board, we can conclude this week's article with more wide-sweeping guidelines in making this very tough decision.

    The RRSP is usually the optimal choice for retirement funding when:

  • investing exclusively in GICs or other investments generating mostly interest income;
  • the identical amount of money is available for both options and at least 34 per cent to 40 per cent of the tax savings can be reinvested elsewhere; or
  • the amount of money available to invest in the RRSP exceeds that available for a regular investment by at least 15 per cent.

    Opting to save for retirement outside of a RRSP is smart when:

  • the identical amount of money is available for both options and less than 34 per cent of the tax savings can be reinvested elsewhere;
  • your regular investments are positioned more aggressively to the extent you can earn an annualized return that is at least 1 percentage point higher than your RRSP; or
  • You expect your tax rate in retirement to substantially exceed that before retirement (i.e. if saving mainly for estate purposes rather than to generate retirement income).

    Last week's article should have illustrated the RRSP's limitations and that occasionally, conventional wisdom should be challenged. I hope this week's article provides a broader view of how various factors impact this decision and reminds us of when the RRSP shines as a financial planning vehicle.

    Next week: the dangers of the proposed CI-Mackenzie merger.

    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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