I can't think of a more debated issue today than whether or not to use an RRSP in saving for retirement. Perhaps the "which came first, the chicken or the egg" issue ranks high on the list, but that debate will never be resolved. As for your retirement savings, I believe the answer is clearer.
The debate has been hot since the Department of Finance knocked the capital-gains inclusion rate down to 50 per cent in October, 2000.
Some argue that Canadians should save for retirement outside RRSPs because the withdrawals from a non-registered, or open, account are more tax-efficient than withdrawals from an RRSP. After all, any withdrawal from a non-registered investment account will not be fully taxed. Only the growth on those investments will be at the time you make withdrawals -- and just one half of that growth will be subject to tax.
Does this argument really hold water? The fact is, there are more issues to consider. Here are six to weigh in the RRSP versus open account debate:
Tax deduction today. When you contribute to an RRSP, you can't ignore the resulting tax deduction where you have the contribution room. This deduction provides tax savings, which, in turn, can be invested.
You won't get this type of deduction when investing outside an RRSP, unless you're borrowing money to invest, in which case you may be entitled to an interest deduction. Borrowing money to invest can make sense for many, but if you're not a good candidate for leveraged investing, the RRSP is the clear winner over investing outside the RRSP.
Tax-deferred income. When investing inside an RRSP, you'll defer the tax on any income until you make withdrawals from the plan. This makes RRSPs pretty compelling, but this benefit is not something I value as much as the tax deduction.
It's possible to invest very tax-efficiently outside of an RRSP in such a manner that you're likely to pay little or no tax over the years on the growth. There are, for example, mutual funds designed for long-term growth that have very low turnover, resulting in very little, if any, tax over time.
Dividing the income. Income splitting is the concept of moving taxable income from the hands of one family member who will pay tax at a high rate to another who will pay at a lower rate. This is easier to accomplish with RRSPs if you want to split income with your lower-income spouse because spousal RRSPs are available. Income splitting with an open account can be done, but it takes more paperwork and ongoing maintenance.
Tax on withdrawals. Here's where an open account wins. RRSP withdrawals are fully taxable whereas withdrawals from your open account are taxed at the preferential capital-gains rates, making them more tax-efficient.
Investment options. An open account provides a little more flexibility in that you can hold virtually any investment outside your RRSP. Even so, most Canadians find the investment alternatives available inside the RRSP more than sufficient. An RRSP will restrict your foreign content to just 30 per cent of the cost amount of the assets in the plan, but even this restriction can be sidestepped easily in a number of ways, including the use of RRSP clone funds.
Psychological benefits. An RRSP wins when it comes to psychological benefits. It has a contribution deadline every year (March 3 this year), making it more likely that Canadians will actually contribute to the plan. With no looming deadline to invest outside an RRSP, it's going to take more discipline to do so.
In addition, Canadians hesitate to make withdrawals from an RRSP because of the tax on those withdrawals. There may not be the same hesitation in the case of an open account.
Let's take a brief look at the numbers to see whether an RRSP or an open account will leave you better off at the end of the day.
Consider a situation where you have $7,500 after taxes available annually to invest. I'm going to compare three scenarios: first, that you contribute that amount to your RRSP annually (assuming you have the contribution room available); second, that you invest that amount in an open account annually; and, third, that you use that $7,500 to cover the interest cost on an interest-only loan and invest outside your RRSP.
In each case, I'll assume you liquidate the portfolio at the end of 20 years, have an 8-per-cent rate of return annually, and a marginal tax rate of 46 per cent.
If you were to contribute that money to your RRSP and also reinvest your tax savings from the contribution annually, you'd have $322,773 after taxes at the end of 20 years.
If you were to invest that $7,500 instead outside an RRSP, you'd have just $298,776 after taxes at the end of 20 years, if you invest tax-efficiently for capital growth (so that you're not taxed annually on any income, but face a capital-gains tax at the end of 20 years when you liquidate the portfolio).
If you used that $7,500 to pay the interest cost on a 7-per-cent, interest-only loan, you'd be able to borrow $107,000 today, and that account would be worth $439,063 after taxes at the end of 20 years, after paying off your loan, if you reinvested your tax savings from the interest deduction annually.
Interesting. With our assumptions, you'll come out ahead in the situation where you borrow to invest outside your RRSP. If you're not a good candidate to borrow to invest, however, and if you fail to invest tax-efficiently outside the RRSP over the years, the RRSP is the clear winner.
What am I doing with my retirement savings? I'm saving both inside and outside an RRSP. My RRSP is a low-maintenance portfolio since I don't have to be concerned about taxes annually.
My open account requires more maintenance to ensure it remains tax-efficient and to service the loan I've taken out, but I like the extra capital that the loan provides. It gives my retirement portfolio a shot in the arm.
Tim Cestnick, CA, CFP, TEP is author of The Tax Freedom Zone and Winning the Tax Game 2003. He is managing director, Tax Smart Services, at AIC Ltd.
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