It has been hanging around in the financial landscape for so long, we think we know everything about the Registered Retirement Savings Plan (RRSP): contributions to the account are eligible for tax deductions, money grows tax-free, Withdrawals are taxable as work income, blah-blah-blah.
In short, the RRSP would simply be an instrument to defer taxes. Here !
No, not quite.
I suggest that you look at the question from a different angle. This new perspective could change the way you think about … your tax refund!
A tax shelter
A few years ago, I came across an original text signed by CPA Éric Brassard, partner at Brassard Goulet Yargeau, a financial services firm located in the Quebec City region.
He says the RRSP is much closer than you might think to its cousin, the Tax-Free Registered Account (TFSA).
According to the specialist, the RRSP constitutes a “pure tax shelter” like the TFSA, the two accounts making it possible to generate tax-sheltered returns.
For the same net contribution, the two registered accounts produce the same result, except that with the RRSP, the cash flows take more winding paths.
The mechanics of the RRSP
I will reproduce here his example, based on a fictitious taxpayer taxed at 40% who contributes $ 1,000 to an RRSP whose return goes up to 8%. The following year, he withdrew his money. This allows us to see the mechanics of the regime at work.
The $ 1,000 contribution entitles you to a tax refund of $ 400 ($ 1,000 x 40%). The taxpayer’s net financial effort, which he takes out of his pockets, therefore amounts to $ 600 ($ 1000 – $ 400).
After one year, the account contains $ 1080 thanks to the 8% return. The saver withdraws the money from the RRSP. Still subject to the 40% tax rate, he must pay $ 432 in tax ($ 1,080 x 40%). He has $ 648 left.
A net contribution of $ 600 to the RRSP provides a tax-free profit of $ 48 (8%).
The TFSA operation
By repeating the experiment with the TFSA, we arrive at the same result. This account is not eligible for tax deductions, and what you get out of it is not added to taxable income.
You therefore have to deposit $ 600 in the TFSA, which also generates an 8% return. One year later, how many are there? Well yes: $ 648.
A net contribution of $ 600 to the TFSA also generates a non-taxable gain of $ 48 (8%).
Flame the tax refund?
What does this demonstration tell us?
That the tax refund resulting from an RRSP contribution is not a gift from the government! This is your hard earned money.
If you blaze it like it’s a check falling from the sky, it’s like, in our example above, a TFSA contribution of $ 600 allows you to squander $ 400.
We are moving away from the objective of a tax shelter.
The difference between an RRSP and a TFSA
There is a big difference between the two types of registered accounts, however. The result of the TFSA is more predictable, it depends only on the performance of the investments within the account.
In the case of an RRSP, the tax rate upon withdrawal can be a game-changer. In the demonstration opposite, we used the same tax rate on entry and exit.
In reality, we don’t know how we’ll be taxed in retirement. If the tax rate is lower at disbursement, the RRSP will have been a good choice. If it is higher, the TFSA would have been the best option.
I’m talking about tax rates, but since RRSP contributions and withdrawals affect taxable income, they have an impact on access to social programs, which results in the famous “marginal effective tax rate”. Or TEMI.
The TEMI includes tax, but also gains and losses in tax credits, family allowances, Guaranteed Income Supplement and all programs modulated according to taxable income. It often exceeds 50%, even among middle-income households.
How do you know where your TEMI will be in 20 years? It is impossible, especially since social programs and taxation can change in the meantime.