Making the case for tax-free investing

National Post


(Charts can be found here:

Other commentators writing in these pages during the current RRSP season have suggested that building up too much money in an RRSP or its successor, a RRIF, could somehow be a bad thing because of the potentially high marginal effective tax rates (METRs) associated with RRIF withdrawals. Your METR takes into account not only your statutory tax rate but also the impact of the loss of any income-tested government benefits.

But would these folks actually have been better off saving outside of an RRSP, where, the argument goes, they could have taken advantage of 50% capital gains inclusion rates and the favourable dividend tax credit for Canadian dividends, both of which are forgone when such income is earned inside a registered plan?

I would suggest that for nearly everyone, the RRSP was still the better choice versus investing the money in a non-registered account. Here's why.

RRSPs allow you to earn tax-free investment income. Not merely "tax deferred" income but actually tax-free income.

Take the example of "Dan" whose marginal effective tax rate (METR) today is currently 33%. Dan can afford to invest $2,000 of his net after-tax cash flow in an RRSP. As a result, he actually contributes $3,000 to his RRSP, even borrowing the extra $1,000 if necessary for a couple of weeks until he gets his tax refund to repay the loan.

Chart 1 shows the after-tax value of Dan's RRSP, invested over 40 years at 5%, as compared with the after-tax value of an equivalent investment had Dan gone the non-registered route. The non-registered investment assumes, somewhat unrealistically, that no income or gains are realized during the accumulation period and, when the entire amount is cashed in at the end of 40 years, a capital gain is realized, taxed at 50% of Dan's METR, assumed to be constant at 33%.

In other words, as long as your METR at the time of making an RRSP contribution is equal to or greater than your expected METR at the time of ultimate RRSP or RRIF withdrawal, RRSP investing will always beat non-registered investing hands down, over any length of time, no matter whether you earn interest, tax-preferred Canadian dividends or half-taxable capital gains had you invested the equivalent amount in a non-registered account.

In fact, the RRSP account would show an even greater advantage over the non-registered account if the non-registered account assumption was more realistic in that annual interest or dividend income was earned and taxed annually or gains were realized occasionally during the accumulation phase and taxed throughout the period rather than merely at the end.

But what if your METR actually increases between now and retirement?

Depending on the rate of return assumption, the number of years of tax-free compounding available as well as the types of investment income you might otherwise earn by saving an equivalent amount in non-registered account, the benefits of the tax-free compounding inside an RRSP or RRIF can actually outweigh the additional tax cost of a higher-withdrawal METR.

Let's model this by using the same assumptions above but this time, assume that Dan's METR increases by a full 10% from 33% to 43% upon retirement. Chart 2 shows that with a 5% return over time and a pure deferral of tax on the non-registered side, it would take 23 years for the after-tax value of the RRSP to beat out the non-registered account. The chart also shows that in this situation, contributing to a TFSA provides higher after-tax values throughout the entire period.

The break-even point is dependent on the rate of return assumption. At an 8% return, the breakeven point comes after only 14 years.

Keep in mind that Chart 2 paints an extreme picture whereby the non-registered account grows free of any tax during the accumulation period and is fully taxed as capital gains at the end of the day. In a more realistic world, the breakeven point would come even sooner if the non-registered savings were taxed throughout the accumulation period and at rates less favourable than that of capital gains.

With the introduction of the TFSA, taxpayers nearing retirement whose time horizons are shorter and whose METRs upon ultimate retirement savings withdrawal are expected to be higher than they were during the period of contribution, finally have a vehicle that allows them to also earn tax-free investment income without being potentially punitively affected.

TFSAs also play an important role in retirement savings for low-income Canadians. A low-income earner would be best advised to maximize his or her TFSA to the extent possible ($15,000 in 2011 if no prior contributions have been made). Any additional savings, however, should be directed to non-registered savings instead of RRSPs due to the potential loss of the Guaranteed Income Supplement (GIS) upon retirement.

In this case, even a full and immediate taxation of investment income annually in a non-registered account is preferable to an RRSP because those in the lowest tax bracket are facing a 20% METR when they contribute but a 50% to 70% METR when they withdraw.

Read my full report entitled, "Just do it: The case for tax-free investing" at