TFSAs may be a no-brainer, but don't fall into the trap of neglecting your RRSP

National Post


While millions of Canadians have embraced the TFSA as a way to save for retirement, we shouldn’t forget that for many of us, RRSPs are still the vehicle of choice for long-term savings. With the RRSP deadline of March 1, 2021 just four weeks away, here are some RRSP stats, and the reason that RRSPs win, hands down, when compared to non-registered investing.

In 2020, Statistics Canada reported that Canadians held a total of $1.4 trillion in RRSPs, RRIFs and locked-in plans. It also reported that in 2018, of the 27.4 million Canadians that filed a personal income tax return, just over six million of them reported having made an RRSP contribution. Nearly one quarter of those that contributed were aged 35 to 44 and the median employment income of a contributor was $64,660. In total, over $43 billion of new money was contributed in 2018, with the median RRSP contribution being $3,130.

If we dig a little deeper by using the Canada Revenue Agency’s income statistics for the 2017 tax year, we learn that of the almost 19 million tax filers who reported income under $50,000, approximately nine per cent claimed an RRSP deduction that year. As income grows higher, however, the percentage of Canadians who claimed an RRSP deduction was significantly larger. For example, for individuals who reported income between $50,000 and $100,000 that year, nearly 41 per cent claimed an RRSP deduction. For the highest income-earners, whose income was over $100,000 (representing 2.7 million Canadians), almost 60 per cent of them claimed an RRSP deduction on their returns.

To claim a deduction on your 2020 return, you need to contribute by March 1, 2021 and the maximum amount you can contribute can be found at the very bottom of your “RRSP deduction limit statement” on your Notice of Assessment. It can also be looked up online using the CRA’s My Account. For 2021, the new RRSP dollar limit is $27,830 or 18 per cent of your 2020 earned income, whichever is lower, less any pension adjustment from your employer. (You have until March 1, 2022 to make this year’s contribution.)

In prior columns, I’ve discussed that for those without enough cash to maximize both RRSPs and TFSAs, RRSPs clearly beat TFSAs for those whose tax rate in retirement is expected to be lower than it was in the year of contribution.

Yet, each year during RRSP season, I come across well-off, highly-educated clients who, while they have fully embraced the tax-free opportunity afforded by the TFSA, often calling it a “no-brainer,” are reluctant to maximize their RRSPs since by doing so, they think they are giving up the tax advantages associated with Canadian dividends and capital gains.

After all, in a non-registered account, Canadian dividend stocks benefit from a lower tax rate due to the dividend tax credit, as well as a 50 per cent inclusion rate on capital gains if the stock is sold at a profit. It’s true that these benefits are, indeed, not available to RRSP income since amounts withdrawn from an RRSP (or its successor, a RRIF), are fully taxable at ordinary tax rates; however, what these individuals have trouble understanding is that these returns, when earned inside an RRSP/RRIF, are effectively 100 per cent tax-free (assuming your tax rate in the year of contribution is the same as in the year of withdrawal). Don’t believe me? Let me illustrate with an example.

Let’s take Shira, an Alberta resident, who earns $80,000 annually and contributes $3,000 of her employment income to an RRSP. Her marginal tax rate is about 30 per cent today and she’s expected to be in the same tax bracket when the RRSP funds are accessed in retirement. If on Jan. 2, 2021 she invested in a dividend-paying stock that had a five per cent dividend yield, by the end of the year, her RRSP would be worth $3,150, assuming no stock appreciation. If she were to then cash in her RRSP, she would net $2,205 ($3,150 less tax of 30 per cent).

Now suppose, instead, Shira preferred not to go the RRSP route and invested $3,000 of her employment earnings in the same 5% dividend-paying stock in a non-registered account, hoping to enjoy the preferred tax rate on those Canadian dividends rather than have them taxed as ordinary income when withdrawn from her RRSP. But, to save $3,000 of her employment income in a non-registered account, she would first have to pay tax of $900 ($3,000 x 30 per cent) on that income before investing the net amount of $2,100. The dividend yield of five per cent would result in 2021 dividends payable to her of $105 ($2,100 X 5 per cent). If we again assume no capital appreciation, at the end of the year, Shira would have $2,100 from her investment and $105 of dividend income on which she would pay combined federal/Alberta tax of approximately $11 owing to the dividend tax credit. So, on a net basis, Shira would only net $2,194 (i.e. $2,100 + $105 – $11) on an after-tax basis vs. the $2,205 she would have netted on her RRSP.

This simple example may, at first glance, seem counter-intuitive. After all, with the RRSP Shira is paying tax on the dividend income at her full, ordinary Alberta tax rate of 30 per cent and if she went the non-registered route, her dividend income is only taxed at a 10 per cent marginal rate on eligible dividends. But, of course, her “net” investment in a non-registered investment is lower, and thus her dividend income is lower, because she had to pay 30 per cent tax on her employment income before she could invest.

Another way to look at is that by contributing to an RRSP, you are effectively getting a 100 per cent tax-free rate of return on your net after-tax RRSP contribution. In this case, Shira’s net (after-tax) RRSP contribution was $2,100 (i.e. $3,000 X (1 – .30)), which at a five per cent return, yields $105 of effectively tax-free dividends.

Finally, I would argue that even if your tax rate is higher in the year of withdrawal (or ultimately, in the year of death) than it was in the year of contribution, you could still be better off with an RRSP than non-registered investments because the benefits of effectively tax-free compounding might actually outweigh the additional tax cost of a higher withdrawal tax rate. This, of course, will depend on your expected rate of return, the number of years of compounding available, as well as the types of investment income you might otherwise earn by saving an equivalent amount in a non-registered account.