Stop Using RRSP if You Earn a Middle-Class Income in Canada
You have better options available
A few weeks ago, in an article “Earning Less than $50,000 in Canada? RRSP may not be good for you?”, I concluded
“For low income Canadians, in most cases, TFSA is a better choice for retirement savings than RRSP.”
RRSPs (Registered Retirement Savings Plans), which have been around for over sixty years, have been promoted by Financial Advisors/Planners so aggressively that most Canadians believe that they are the best investment vehicles for retirement savings for everyone. In that article, I compared two retirement savings options: RRSPs and TFSAs, and the verdict was clear that TFSA is a better option for retirement savings for Canadians earning less than $50,000 per year. I was curious to see if better retirement savings options are available for middle-class Canadians.
What is a Middle-Class in Canada?
There is no clear definition of middle-class in Canada. According to Statistics Canada’s Canadian Income Survey, 2019, “The median after-tax income of Canadian families and unattached individuals was $62,900 in 2019.” However, this is median after-tax income, not average income. There is another way to look at the middle class, and that is through the federal Income tax brackets. The 2021 federal income tax rates are shown here.
One option to define the middle-class income is using the second tax bracket, i.e. individuals having annual taxable income between $49,021 up to $98,040, and I am using this definition for this article. I will compare retirement savings options for two individuals earning $70,000 per year.
Retirement Savings Options for $70,000 Annual Income
John and Bob, residents of Ontario, started working at age 25 after completing their studies. After gaining some experience, at age 30, in January 2021, both landed a job that pays $70,000 per year. They will work until age 65 and then retire. They are in good health and expect to live to age 90, so they will live off their savings and government benefits for 25 years, and the balance amount will be passed to their children/beneficiaries when they die.
John — the RRSP Saver
John decides to save for retirement in an RRSP account. For an annual income of $70,000, the RRSP contribution room is 18% of $70,000, i.e. $12,600, which John wants to utilise entirely. First, let us have a look at the 2021 income tax return of John, if he saves $12,600 in an RRSP account. I plugged the numbers in the Wealthsimple Income Tax Calculator and got the following results.
As apparent from the results, for $70,000 annual income, John, who is resident of Ontario, needs to pay $13,478 tax (including CPP and EI premiums) and will have an after tax income of $56,522. However, as he has invested $12,600 in an RRSP account, he will have $43,922 in his hand to spend, as summarized in the following table.
John invests $12,600 in an RRSP account that grows by 6% annually. To keep the analysis simple, let’s assume that John’s income stays the same and he continues to save and invest $12,600 every year for the next 35 years in his RRSP account. At that point, he would be 65 and retire, and would have $1,488,323 in his RRSP account. Notice that I have hidden rows 17–31 of the spreadsheet that contain data for years 14 through 28 to keep the size of the image small.
Bob does not Like RRSP
Next, let us turn our attention to Bob who does not want to invest in an RRSP account, therefore he needs to pay income tax on the entire salary income of $70,000, which is $17,214 as per 2021 tax rates for Ontario. Thus, after-tax income would be $70,000 minus $17,214, i.e. $52,786. Out of the after tax income, Bob decides to save and invest $8,864, which would leave him with $43,922 in hand, as summarized in the following figure.
At this stage, both John and Bob have the same amount in hand after paying different taxes, CPP & EI premiums and investing different amounts. While John invests $12,600 in the RRSP account, Bob invests $6,000 in a TFSA account and $2,864 in a non-registered investment account.
What’s a Non-registered Investment Account?
Like TFSA accounts, you invest tax-paid amounts in non-registered accounts, however the growth (interest, dividends, capital gains, etc.) in these accounts is taxable. The following three points make non-registered investment accounts special and different from registered accounts (RRSP, TFSA, RRIF, RESP, etc.)
- Certain types of growth, e.g. interest and dividend are included in the current year’s income and taxed in that year’s tax return. For example, if you earn a $1,500 dividend income in 2022, it will be included in your 2022 tax return.
- Capital gains (and losses) are not included in a tax return until these are realized. For example, assume that you buy 100 shares of ABC Company at $100 each for a total amount of $10,000. If the share price doubles to $200 by the end of the year, you have made a capital gain of $10,000, however, you don’t need to include this amount in your tax return. You will need to include the capital gains (or losses) in your tax return only when you sell those shares, which could be anytime in future.
- The most important point that goes in the favour of non-registered accounts is that capital gains and dividends receive preferential tax treatment! As of Jan 2021, only 50% of capital gains are taxable, i.e. on a capital gain of $10,000, you pay tax on only $5,000 and the other $5,000 is tax free. Similarly, dividends are also taxed very favourably. In some provinces, in the low income tax bracket, dividend income tax credits can even result in reducing the total tax payable!
The preferential tax treatment of dividends and capital gains is a very helpful tool in retirement planning, as you will see in this article.
Bob’s Income Tax Calculations
We need to adjust Bob’ tax calculations slightly as dividend income is taxable in the year it is earned. Let us assume that Bob’s non-registered account also grows by 6% per annum, like John’s RRSP account, half of which is dividend income and the other half is capital gains. Bob’s dividend income comes mostly from Canadian companies. The dividend income, after paying tax on this income, will result in increasing the net amount in Bob’s hand. To keep the net amount in hand for both, John and Bob the same, we will reinvest the extra amount back in Bob’s non-registered account. Figure 5 displays details for John’s non-registered account and Figure 6 displays income tax calculations for Bob.
For Year 1, Bob earns a dividend income of $86, which increases payable tax by $5. So, Bob reinvests $86 minus $5, i.e. $81 in his non-registered account in Year 2, shown in the 4th column (Dividend Income from Previous Year Reinvested) of row 5 in Figure 5. This extra deposit of $81 together with additional deposit of $2,684 in Year 2 results in bigger dividend income, which in turn results in bigger reinvestment amount in Year 3, and so on. At the end of Year 35, the value of Bob’s non-registered account will be $310,063 plus the dividend reinvestment amount of $8,293 (from Year 35), i.e. $318,356.
Bob’s TFSA Account
Bob invests $6,000 every year for 35 years and the account keeps growing at 6% per annum. As growth inside a TFSA account is tax-free, it does not impact payable taxes in any way. Figure 7 displays Bob’s TFSA account details.
At the end of 35 years, the value of Bob’s TFSA account will be $708,725. Thus, together with the non-registered account ($318,356), Bob has accumulated $1,027,081, significantly less than $1,488,323 in John’s RRSP account. Looks like that Bob is behind John, but let’s see what happens during retirement.
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.
Continue Reading: Part 2: The Retirement Journey
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