Sorry, there’s no free money with RRSPs despite what you’ve been told

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Banks and financial advisers have done such a thorough job of marketing registered retirement savings plans (RRSPs) that they have completely pulled the wool over the eyes of investors, and even the advisers themselves may not fully understand the nuances.

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They have most of us believing that if you make an RRSP deposit, you get rewarded with an instant tax refund of new free money that you can fritter away on whatever you please. For example, a taxpayer in a 50-per-cent tax bracket can expect to get a $10,000 tax refund after an RRSP deposit of $20,000. On top of that, you still have your $20,000 invested, tax deferred, for your long-term future or retirement.

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Unfortunately, it does not work that way. Simply put, there is no free lunch.

In addition to the “free money” myth, advisers promote the completely incompatible theory that a tax-free savings account will give you the same long-term result as an RRSP, provided there is no change in your tax bracket. How can that possibly be if there is no tax refund associated with the TFSA, and the TFSA is completely tax free on withdrawal?

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Let’s take another look at these RRSP myths.

1) The RRSP deposit creates additional wealth in the form of a tax windfall: Absolutely false.

2) The RRSP is a long-term tax deferral: Again, false. The “deferred” tax must be kept on prepaid deposit and is not accessible. It is clearly out of pocket and out of budget. Agreed, it does not become a tax until actually remitted to the Canada Revenue Agency (CRA), but neither is it a deferred expenditure. The only real deferred tax in this scenario is the deferred revenue on the CRA’s side of the table.

3) The RRSP will give the same long-term result as TFSA: Technically true, but not clearly understood and, consequently, not usually true in real life.

Let’s be clear. No taxes are saved nor deferred with an RRSP deposit. And the TFSA or RRSP result is identical only if the initial RRSP deposit is far greater than the TFSA, and there is no change of tax bracket.

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For example, consider two 50-per-cent taxpayers. Taxpayer A makes a $10,000 TFSA investment, while taxpayer B makes a $20,000 RRSP investment. The extra $10,000 is required to keep pace with the TFSA, otherwise the RRSP will fall way behind. This extra is also required to prefund the future tax liability.

B gets a $10,000 tax-saving refund as a direct consequence of their RRSP deposit and now has a $10,000 investment in the RRSP ($20,000 less $10,000 refund), but it looks like $20,000 on the monthly RRSP statement.

The RRSP looks like $20,000 but it is only $10,000 of B’s investment plus a $10,000 deposit on account of future taxes. It is also only worth $10,000 to B as that would be their net proceeds on withdrawal after the CRA gets its share. Any investment is only worth what it can be liquidated for after tax.

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Note that both A and B are equal in that each has an investment worth $10,000, and each has $10,000 skin in the game after all the dust settles.

Also note that B saved $10,000 of current tax, but had to deposit it in advance to fund the prepaid future tax. Current tax saved into one pocket; future tax prefunded out of another pocket. No tax saved. No tax deferred. No free money wealth accretion.

Eventually the market doubles. How long it takes is not relevant as the result is the same.

A now has a $20,000 TFSA, which they cash out and get $20,000 in pocket tax free. B has a $40,000 RRSP which they cash out, but only get $20,000 in pocket (also tax free) as they must forward the $10,000 prepaid tax deposit plus the $10,000 prepayment gain to the CRA. Kind of like having a joint account where B puts in $10,000 and the CRA puts in $10,000 and they share the profits.

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To recap for non-believers: B cashes out $40,000, which represents their initial net investment of $10,000, returned tax free, their $10,000 portion of the gain, returned tax free, their prepaid tax deposit of $10,000 which is now due to the CRA, and the CRA’s $10,000 gain on the prepaid deposit, also now due to CRA.

A doubled their money tax free with the TFSA; B doubled their equal net $10,000 investment tax free with the RRSP.

That’s why myth No. 3 above is technically correct. Note that it is necessary to bump your RRSP contribution by a function of your tax bracket to keep pace with the TFSA. If the initial deposits are equal, RRSP loses every time.

The math does not lie.

Advisers may argue that the RRSP usually wins since withdrawals in retirement will normally attract a lower tax rate than at deposit time. True, if that is the case. But most taxpayers will not experience a lower tax bracket in retirement, and many will be in a higher bracket at withdrawal or death.

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Indeed, 65 per cent of all tax filers currently make less than $50,000, and are in the lowest tax bracket of 20 per cent. They will never be at a lower rate, but risk going higher.

Retirees with income of less than $30,000 may receive Old Age Security/Guaranteed Income Supplement benefits. These are subject to clawback at the rate of 50 per cent of RRSP withdrawals, or any other taxable income. Combined with the regular 20-per-cent tax rate at this income level, you could get bumped to an effective marginal tax rate of 70 per cent. Approximately 40 per cent of seniors are subject to the clawback. It is tragic that the highest effective tax rate is reserved for the lowest-income seniors.

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Seniors with 2022 income of more than $81,761 ($86,912 in 2023) are subject to the regular OAS clawback at 15 per cent. Here, the combined effective tax rate approaches the top rate.

Most people who have substantial RRSPs are relatively financially astute, and may have accumulated some additional wealth during their lifetime. Additional wealth combined with CPP, OAS and the mandated registered retirement income fund (RRIF) withdrawal after age 71 attracts high tax rates.

Finally, most seniors are reluctant to consume capital. As a result, many will die with substantial RRSP/RRIF balances that may be subject to top rate tax (at 53.54 per cent in Ontario).

As a result, most seniors will not enjoy a lower RRSP/RRIF tax rate on withdrawal, retirement or death.

Paul Rastas is a retired CPA, CA, CFP, with more than 50 years experience in Canadian tax planning and compliance.