How to get a bigger benefit from your RRSP contribution

Q. I am a hairdresser and my retired clients are telling me not to contribute to RRSPs because of all the tax they have to pay on withdrawals. Instead, they say I should contribute to a TFSA because the withdrawals are tax-free. What should I be doing?
–Julie 

A. Hi Julie. This may sound surprising at first, but I am going to suggest that a registered retirement savings plan (RRSP) and a tax-free savings account (TFSA) provide the same “tax-free” benefit and that there is no difference! They just look and feel a little different.

I bet the reason you’re hearing those comments is because most people don’t know how to make a proper RRSP contribution and they forget, or don’t recognize, the benefits of tax-sheltered growth.

Most people earn money at work, tax is taken off by their employers, and what’s left is deposited into their bank account. Then they use that money—after tax has been deducted—to make an RRSP contribution. When they file their income taxes for the year, Canada Revenue Agency (CRA) deposits their RRSP tax refund in their bank account and the money tends to disappear, often going to day-to-day expense or towards a vacation.

That is the wrong way to make an RRSP contribution—and if you do it that way you’re likely better off contributing to a TFSA.

Let’s run the numbers, and you’ll see what I mean. Below is an example of someone contributing $20,000 from their bank account (after tax) to both a TFSA and an RRSP. In this case, the RRSP tax refund disappeared into day-to-day expenses.

You can see in the table above that in 20 years the RRSP and the TFSA grow to the same amount of money, but there is about a $16,000 difference in favour of the TFSA once the money is withdrawn.

Julie, in this example your clients’ advice is correct: the TFSA is better. But now let’s look at what happens when you make a proper RRSP contribution.

The key to making a proper contribution is to think about your pre-tax income. How much did you have to earn before your $20,000 was deposited into your bank account?

Here is the formula to use to figure it out:

Contribution amount / (1 – your marginal tax rate) = Pre-tax earnings

Assuming a marginal tax rate of 30%, here is the formula using numbers:

$20,000 / (1 – 30%) = $28,571

What the formula is telling us is that anyone with a marginal tax rate of 30% must earn $28,751 (gross before tax) to have $20,000 deposited (net after-tax) into their bank account.

Now let’s compare a $20,000 after-tax contribution to a TFSA against a $28,571 before-tax contribution to a RRSP.

After withdrawals and tax, the TFSA and the RRSP have the same value. If a TFSA is tax-free, how can you argue that an RRSP does not provide the same tax-free growth if the final after-tax values are the same?

Now let’s see what happens if your marginal tax rate changes at the time of withdrawal:

As you can see, the RRSP beats the TFSA when your marginal tax rate is lower than it was when you contributed, which is the case for most people. If your marginal rate was higher at the time of withdrawal, then the TFSA wins.

The tricky part with all of this is making a pre-tax RRSP contribution.

If you have a group RRSP at work, then you are doing it without possibly even knowing it. However, if you don’t have a group RRSP, you have a couple of options:

1. Complete this form to have your employer reduce the amount of tax they withhold from your earnings. It is not that difficult. If you do this, make sure you contribute $28,571 to your RRSP over the course of the year rather than the $20,000, using the example above.
2. In February, take out an RRSP loan (or other loans) for $8,571 and add it to your $20,000 after-tax contribution. The RRSP tax refund will be $8,571, which you will use to pay off the loan. I suggest taking the loan in February because then you will only have to pay a month or two of interest before you can pay off the loan with your tax refund.

So there you have it. I would argue that an RRSP is better for most people when a proper contribution is made. Unfortunately, most people do not make proper RRSP contributions. Another thing to be aware of is that whenever you read about RRSP and TFSA comparisons, in most cases, the writer assumes a proper RRSP contribution which, again, most people don’t make.

There are a number of other reasons why an RRSP may or may not be the best investment choice, but your financial planner can help you with that. And remember, don’t get too hung up on which one is best—the bigger mistake is not to invest at all.

Allan Norman is a Certified Financial Planner with Atlantis Financial Inc. and can be reached at www.atlantisfinancial.ca or [email protected]

This commentary is provided as a general source of information and is intended for Canadian residents only. Allan offers financial planning and insurance services through Atlantis Financial Inc.

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