RRSP, TFSA integral to a retirement plan

The popular notion that RRSPs are only tax-deferred while TFSAs are tax-free is rooted in misconception, says Jamie Golombek, managing director of tax and estate planning at CIBC.

“This is simply incorrect. No matter which plan you choose, you have the ability to earn tax-free investment income for life – an opportunity that no one should pass up,” he says. “With the 2010 Registered Retirement Savings Plan (RRSP) contribution deadline fast approaching, Canadians need to stop procrastinating and just contribute.”

It’s important not to lose sight of the fact that both plans offer a key benefit: tax-free accumulation of investment income, says the tax expert.

In a report entitled, Just Do It: The Case for Tax-Free Investing, Golombek shows how growth inside an RRSP is indeed tax free. He uses an example of an individual with a 33% marginal effective tax rate (METR) who can afford to invest $2,000 in an RRSP. Golombek argues that investor should actually contribute $3,000 to an RRSP, borrowing the extra $1,000 if necessary. At a 33% METR, that $3,000 will generate a tax refund of $1,000, for a net investment cost of $2,000–the amout budgeted for retirement savings.

Investing that $3,000 at 5% for one year will see the RRSP grow to $3,150. If the investor cashes out of the RRSP the following year, based on that same 33% tax bracket, he or she will pay $1,050 in tax. That leaves a balance of $2,100, a 5% tax-free return on the $2,000 investment.

The report illustrates that should the investor leave the money in his or her RRSP for 40 years, the $3,000 RRSP investment would grow to more than $21,000. Assuming the investor is still in the same 33% tax bracket at retirement, the after-tax value would be $14,080. If he or she elected instead to invest $2,000 in a non-registered account at the same rate of return for 40 years, it would grow to $14,080 and then be subject to capital gains tax, reducing the after tax value to $12,067 – $2,013 less than if the money was put into an RRSP.

“Clearly, the RRSP beats the non-registered account when [the tax rate] stays the same upon ultimate withdrawal, due to the tax-free investment income earned in the RRSP,” he says.

If the tax rate is lower upon retirement than it was upon contribution, the relative advantage of the RRSP over non-registered savings would be that much greater. “Income and growth inside an RRSP (or its successor, a RRIF) is indeed completely tax-free.”

For many Canadians, he says, investing in your RRSP is the wise thing to do even when your METR is expected to be greater upon retirement than while contributing.

“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 a non-registered account, the benefits of the tax-free compounding can actually outweigh the additional tax cost of a higher withdrawal METR.”

The benefit of tax-free accumulation of investment income inside an RRSP can still outweigh non-registered investing, once the TFSA is maximized.

“In other words, in nearly all cases, no matter your tax rate now or in the future, RRSP or TFSA investing should be an integral part of your retirement plan. Just do it!”