Earning Less than $50,000 in Canada?
RRSP may not be good for you
RRSPs (Registered Retirement Savings Plans) have been around for over sixty years and have been promoted by Financial Advisors/Planners so aggressively that many Canadians believe that they are the best investment vehicles for retirement savings for everyone. On the surface, RRSPs look great as they offer two tax advantages — first, you put contributions in a RRSP plan on a tax free (pre-tax) basis and the second, your investments in an RRSP account continue to grow tax free. In other words, if you earn $50,000 in a year and contribute $5,000 in an RRSP account, you pay income tax only on $45,000, and $5,000 that you have contributed to an RRSP account will continue to grow tax-free indefinitely, as long as you don’t withdraw the money from the RRSP account, i.e. you don’t pay any tax on interest, capital gains and dividends on your investments in your RRSP account. That looks great, however there is a catch — any money you withdraw from an RRSP account is 100% taxable and is added to that year’s income. For example, if your income in a particular year is $40,000 and you withdraw $15,000 from your RRSP account, your income for that year would be considered as $55,000 for tax purposes.
Financial Advisors/Planners tell people that during the saving/contribution phase, they are in higher income tax slabs, and during the withdrawal (retirement) period, they will be in lower tax slabs as their income during retirement will be less than that during the working (contribution) phase. In other words, people will save more tax when they contribute money in RRSP and pay less tax when they withdraw from it during retirement. This makes sense for some people, e.g. if you are in the 40% marginal tax bracket during the contribution phase and 20.05% during the withdrawal phase. But, if you are in the lowest tax bracket during the contribution phase, it is possible that you might end up paying more tax during retirement than what you saved (when you contributed to RRSP), as well lose some income tested government benefits and credits. Before I explain that, let me talk about TFSA, an alternative to RRSP.
TFSA — The New Kid on The Block
TFSA, which was introduced in the 2008 federal budget and came into effect on Jan 1, 2009 is not so new, though it is still not fully understood by many. First, it’s name TFSA, i.e. Tax-Free Savings Account is confusing — it is not a cash savings account at the bank; in fact, it is a registered account and can hold most common types of investments, e.g. Stocks, bonds, mutual funds, ETFs (Exchange Traded Funds), GICs (Guaranteed Income Certificates) and cash, like an RRSP account. However, there are some key differences between RRSP and TFSA.
- Unlike RRSP, you make a contribution to an TFSA account from your tax-paid money. In other words, you don’t get a tax rebate when you invest in a TFSA account. If you still find it confusing, I will explain it in detail later in this article.
- When you withdraw money from TFSA, you don’t pay any income tax on that amount. In fact, it is not even considered income for any purpose, whatsoever. On the other hand, any withdrawal from an RRSP account is 100% taxable and is added to that year’s income.
- Current year’s RRSP contribution room is based on the 18% of the earned income during the previous year, subject to a maximum limit set by Canada Revenue Agency (CRA). On the other hand, every Canadian resident who is 18 years or older gets the same TFSA contribution room, which is $6,000 in 2022, unchanged from 2021.
- Whereas the RRSP contribution room is based on last year’s earned income, the TFSA contribution room is not linked to the earned income at all. Therefore, if you did not earn any income in the previous year, your RRSP contribution room for the current year will be zero, however you still get the full TFSA contribution room like any other resident.
- You can withdraw money from your TFSA or RRSP accounts anytime. If you withdraw an amount, say $2,000 from your TFSA account, this amount is added to your TFSA contribution room the following year, i.e. next year, your TFSA contribution room will be $2,000 plus $6,000 plus any unused contribution room from previous years. On the other hand, when you withdraw money from your RRSP account, you never get back that contribution room.
Note: Unused contribution room is carried forward to the next year for both RRSP and TFSA. And, if you were at least 18 years old in 2009 and have been resident of Canada since then and have not contributed anything to your TFSA account, as of 2022, you can contribute $81,500 to your TFSA account.
Growth of Money in RRSP and TFSA is Exactly the Same
It is a myth that because you put untaxed money in an RRSP account and tax-paid money in TFSA, and because money grows tax free (in both accounts), you will have more money in future in the RRSP account at the time of retirement. Let us have a closer look at this issue with a practical example. Both John and Bob earn $46,000 a year and live in Ontario. John contributes $6,000 in his RRSP account. As no tax is payable on contributions to RRSP accounts, John does not pay any income tax on $6,000 and the full amount gets deposited into his RRSP account. (John pays tax on only $40,000 income). Bob also has $6,000 pre-tax money available to invest, however as he wants to invest money in a TFSA account, therefore he needs to pay tax on $6,000 and then only he can invest the tax-paid amount ($6,000 minus tax on $6,000) in a TFSA account. The current combined Federal and Ontario tax rate for $46,000 annual income is 20.05%. Let us assume that the tax rates do not change in future and both RRSP and TFSA accounts grow 6% annually for the next 25 years, and then the entire amount is withdrawn from both accounts. The question is: who will have more money in hand, John or Bob?
First, let us have a look at John’s RRSP account, as shown in the following figure.
On the $6,000 invested in the RRSP account of John, there is a growth of $19,751 @ 6% compounded annually for 25 years, thus the total amount in the RRSP account after 25 years would be $6,000 plus $19,751, i.e. $25,751. When this amount is withdrawn from the RRSP account, John would need to pay income tax on the entire amount, which at the minimum Ontario tax rate (20.05%) will work out to be $5,163, so the net amount in John’s hand would be $20,588.
Next, let us have a look at Bob’s TFSA account shown in the following figure.
Bob first has to pay income tax @20.05% on the $6,000 before he can invest the money in the TFSA, thus the net amount invested in the TFSA account is $4,797. This amount grows for the next 25 years @ 6% compounded annually, which works out to be $15,791. Thus, at the end of 25 years, the total amount including the original invested amount becomes $20,588. As no tax is payable on withdrawal from the TFSA account, Bob will have $20,588, which is exactly the same as John would get from his RRSP account!
You see that at the end, the net amount in hand is exactly the same in both cases!
Myth About RRSP Tax Refund
You may ask, “Won’t I lose the tax refund from CRA if I don’t invest in RRSP?” No, the tax refund you get from CRA is the refund of the tax you have pre-paid through tax deductions at source. In other words, when you invest an amount in an RRSP account, CRA refunds the tax already paid on that amount, and you don’t get any extra tax refund.
RRSP may Push You in a Higher Tax Bracket
If you save a lot in your RRSP account, when the time comes to withdraw money, you may end up in a higher tax bracket, thus may have to pay a higher tax on withdrawal. Remember that in this article, we are talking about people in the lowest tax bracket, therefore, in the withdrawal phase, you can never be in a tax bracket lower than when you contributed to you RRSP account, unless the Government decides to slash the taxes, chances of which are very slim, particularly after the pandemic.
If you need to withdraw a large sum of money from your RRSP account for an emergency while you are still working, it will most probably push you in a higher tax bracket. For example, let us assume that you normally earn about $50,000 per year, so you are in the lowest tax bracket and accordingly save the least tax when you contribute to your RRSP account. Now if you need $30,000 for an emergency and decide to withdraw it from your RRSP account, this will definitely push you into a higher tax bracket. In fact, you will need to withdraw a higher amount, perhaps $40,000, as you need to pay income tax on the RRSP withdrawals. On the other hand, if you withdraw money from your TFSA account, you just withdraw $30,000 and you don’t need to worry about taxes.
RRSP Withdrawals May Reduce Old Age Benefits
Another important point to consider is that RRSP withdrawals may decrease certain income tested government benefits and credits, such as GIS (Guaranteed Income Supplement), OAS (Old Age Security), Age Amount Tax Credit and GST/HST refund. Of these 4 benefits, the GIS is affected most by withdrawal from RRSP or RRIF (Registered Retirement Income Fund) for low income retired seniors (65+). Let us take the case of Maya, 65 years old, who is a single person and has lived more than 40 years in Canada since she turned 18, thus, she gets full OAS. In addition, let us assume that she also gets $4,000 annually as CPP (Canada Pension Program) benefits. According to the Guaranteed Income Supplement (GIS) table published on the Government of Canada website, a senior, who is getting the maximum OAS and has an annual income of $4,000 excluding OAS and GIS, is entitled to a monthly GIS payment of $752.26, i.e. $9,027.12 annually.
Next, assume that Maya withdraws $6,000 from her RRSP or RRIF account, so her annual income now increases to $10,000 as all RRSP/RRIF withdrawals are considered as income. According to the Guaranteed Income Supplement (GIS) table, for $10,000 annual income, excluding OAS and GIS, Maya’s monthly GIS payment would be $394.68, i.e. $4,736.16 annually. That is, a $6,000 RRSP/RRIF annual withdrawal caused a reduction of $4,290.96 ($9,027.12 minus $4,736.96) in GIS payments, not a small reduction! On the other hand, if Maya withdraws the same amount from her TFSA account instead of RRSP account, there would be no reduction in the GIS payments, as withdrawal from a TFSA account is not considered as income. Thus, with TFSA withdrawals, Maya would end up with $4,290.96 higher net income as compared to RRSP withdrawals. In the same way, withdrawal from RRSP may reduce other income tested benefits too, though not so much as GIS.
Note: The GIS numbers used in this article are taken from the published data as of Jan 2022, however, these might change in future as GIS payments are indexed to inflation.
Conclusion
For low income Canadians, in most cases, TFSA is a better choice for retirement savings than RRSP.
Disclaimer: The information provided in this article is for educational purposes only and does not constitute investment advice. Please consult your financial advisor before making any investment decisions.
See Related Articles
If you enjoyed this…
If you liked this, follow me and 👏 👏 👏 a couple of times. I also look forward to your comments/feedback.
