Stop Using RRSP if You Earn about $90,000 per Year in Canada
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In Part 1 and Part 2 of this series, I analysed the savings and retirement phase of John and Bob, residents of Ontario, who earn $70,000 a year, where John used an RRSP account to save money for retirement, whereas Bob used TFSA and non-registered accounts. And, I concluded that Bob, who did not use RRSP, was way ahead of John. I was eager to see who would be ahead if their income was $90,000 per year. Let us explore this.
Note: If you need more information about an RRSP or TFSA account, click here, and click here to learn more about non-registered accounts.
John — the RRSP Saver
For an annual income of $90,000, the RRSP contribution room is 18% of $90,000, i.e. $16,200, which John wants to utilise entirely. As per 2021 tax calculations for a resident of Ontario, here is the tax summary of John.
John invests $16,200 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 $16,200 every year for the next 35 years in his RRSP account. At that point, he would be 65 and retire, and would have $1,913,558 in his RRSP account. Notice that I have hidden rows 17–31 of the spreadsheet that contain data for years 9 through 30 to keep the size of the image small.
Bob does not Like RRSP
Bob does not want to invest in an RRSP account, therefore he needs to pay income tax on the entire salary income of $90,000, which is $23,443 as per 2021 tax rates for Ontario. Thus, after-tax income would be $90,000 minus $23,443, i.e. $66,557. Out of the after tax income, Bob decides to save and invest $11,247, which would leave him with $55,310 in hand, exactly the same as John’s in hand amount, as summarised 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 $16,200 in the RRSP account, Bob invests $6,000 in a TFSA account and $5,247 in a non-registered investment account.
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 2 displays details for John’s non-registered account and Figure 3 displays income tax calculations for Bob.
For Year 1, Bob earns a dividend income of $157, which increases payable tax by $14. So, Bob reinvests $157 minus $14, i.e. $143 in his non-registered account in Year 2, shown in the 4th column (Dividend Income from Previous Year Reinvested) of row 5 in Figure 2. This extra deposit of $143 together with additional deposit of $5,247 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 $546,333 plus the dividend reinvestment amount of $12,574 (from Year 35), i.e. $558,907.
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 4 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 ($558,907), Bob has accumulated $1,267,632, significantly less than $1,913,558 in John’s RRSP account. Looks like Bob is behind John, but let’s see what happens during retirement. Let us assume that John and Bob need $60,000 per year during retirement.
Bob’s Retirement Journey
At age 65, Bob is entitled to OAS (Old Age Security) and CPP benefits. As Bob has lived in Canada for over 40 years since he turned 18, he would be entitled to the maximum OAS payment, which as of Jan 2022 is $642.25 per month, i.e. $7,707 per year. As Bob’s income during the working phase has been more than the maximum annual pensionable earnings, he would get the maximum CPP benefit, which is $14,445 per year as of Jan 2022. Though OAS and CPP payments are indexed to inflation, for our exercise, we are keeping these constant. So, the total income during retirement would include withdrawals from non-registered & TFSA accounts, OAS payments and CPP payments, of these, all except withdrawals from TFSA are taxable.
During the retirement phase too, let us assume that Bob’s non-registered account will continue to grow 6% annually, with 3% dividend income and 3% capital gains, which Bob would withdraw for his needs during retirement. As withdrawals from the non-registered account together with CPP and OAS benefits will not make $60,000, Bob would withdraw $6,850 annually from his TFSA account to make up for the deficit. This would become clear when you look at Figure 5 (Bob’s Non-Registered Account during retirement) and Figure 6 (Bob’s retirement income calculations.)
As shown in Figure 6, Bob’s total income from CPP, OAS, dividend and capital gains is $55,253, on which only $2,536 income tax is payable. Notice that Bob pays so little tax because of the preferential tax treatment for eligible Canadian dividends and capital gains (only 50% of capital gains is taxable.)
Note: I have assumed that income tax rates have not changed during the retirement phase. The tax calculations are based on 2021 tax rates for Ontario.
As Bob withdraws $6,850 from his TFSA account tax-free, the effect of this withdrawal on Bob’s TFSA account and its growth is illustrated in Figure 7.
Next, assume that Bob dies at 90, without collecting any CPP and OAS benefits during that year. The final tax return of Bob would include taxable income from all accounts, however, as withdrawals from the TFSA account are tax-free, he only needs to pay tax on his non-registered account. Here too, only unrealized capital gains during the working phase are taxable, as taxes on capital gains and dividends during the retirement phase have already been paid (these have been included in tax returns for age 65 through 89.).
The value of the unrealized capital gains is $205,182 (see Figure 2), and tax on this works out to be only $25,384. The tax bill is so low as only 50% of capital gains are taxable. Here is a summary of Bob’s final tax bill and the value of the non-registered account after paying tax that can pass to his beneficiaries.
So, Bob’s beneficiaries will get $3,176,908 from his non-registered and TFSA accounts after his death, as shown here.
John’s Retirement Journey
Like Bob, John too retires at age 65 with $1,913,558 in his RRSP account. Now, he needs to withdraw money from his savings. He can either withdraw money from his RRSP account or convert it to a RRIF (Registered Retirement Income Fund) account. The investments inside a RRIF account too grow tax-free like an RRSP account. The federal income tax rules require you to liquidate your RRSP account or convert it to RRIF (or other approved options) latest by the year you turn 71, however, you can convert RRSP to RRIF as early as age 55.
The major difference between RRSP and RRIF is that you are required to withdraw a specified minimum percentage of the RRIF account value every year. The minimum required withdrawal percentage starts at 4% at age 65 and gradually increases to 20% at age 95. Of course, all withdrawals from RRIF (or RRSP) are 100% taxable.
To keep our analysis simple, let us assume that John converts his RRSP account to RRIF at age 65. We also assume that John withdraws the minimum required amount from the RRIF account at the beginning of the year, and the balance investments in the account grow by 6% per annum. The RRIF withdrawals and growth of the account is illustrated in Figure 8.
At age 65, like Bob, John is also entitled to $7,707 per year OAS (Old Age Security) benefits and $14,445 CPP benefits. So, the total income during retirement would include RRIF withdrawals, OAS payments and CPP payments, all of which are taxable. Figure 9 displays the income tax calculations for John which includes RRIF withdrawal amounts from Figure 8.
Note: I have assumed that income tax rates have not changed during the retirement phase. The tax calculations are based on 2021 tax rates for Ontario.
Figure 9 needs a bit of explanation. First, it includes a column called “OAS Clawback”. The OAS clawback is triggered when the taxable income is higher than a predefined threshold, which for the 2021 tax year is $79,845. Therefore, when a person’s income, who receives OAS, exceeds the threshold, he/she is required to pay back 15% of the income above the threshold, called the OAS Clawback payment. In other words, OAS clawback results in reduction of the OAS benefits payments by 15 cents for every $1 of income above the threshold value. In Figure 9, for Year 65, as the total income ($98,694) is $18,849 higher than the threshold ($79,845), John will have to pay back 15% of $18,849, i.e. $2,827 to CRA as OAS Clawback payment. Indirectly, OAS clawback results in an additional tax equivalent to 15% of income exceeding the threshold amount, as long as the OAS clawback is less than the OAS benefits.
Notice that during the first year of retirement, John pays $24,938 as Income tax including OAS clawback, significantly higher than he paid during the working phase. The total income and tax payable keeps increasing every year, thanks to the mandatory minimum RRIF withdrawals that keep increasing every year.
You would recall Bob’s net income in hand after taxes is $60,000 a year, while John is getting much higher after tax income. To compare apples with apples, let us save John’s extra income above $60,000 (shown in the last column of Figure 9) in TFSA and non-registered accounts. John has accumulated $285,500 in TFSA contribution room when he retires, and he would also get $6,000 in additional TFSA contribution room for each year in retirement (I have kept TFSA contribution room unchanged at $6,000 since 2021.) I will first put money in the TFSA account, and when the TFSA room runs out, I will put the money in a non-registered account. Both accounts will grow by 6% every year. Figure 10 displays John’s TFSA account and Figure 11 displays John’s non-registered account.
John’s TFSA account runs out of accumulated TFSA contribution room in year 78, so the first contribution of $33,703 is made to the non-registered account. After that TFSA account gets $6,000 and the rest is invested in the non-registered account. To keep the tax calculations for year 78 through 89 simple and to give tax advantage to John, let us assume that all gains in the non-registered account are capital gains.
Next, let us assume that like Bob, John too dies at 90, without collecting any CPP and OAS benefits in that year. The final tax return of Bob would include taxable income from all accounts, however the most important is his RRIF account, whose value is $1,483,211 (see Figure 8). When a RRIF (or RRSP) account holder dies, the general rule is that all values of RRSP or RRIF at the date of death are included in the income of the deceased for the tax return for the year of death. If the RRIF/RRSP account holder has a surviving spouse, the RRSP/RRIF account can be transferred to the spouse tax-free. In our case, to keep it simple, let us assume that John dies without a surviving spouse with a RRIF account value of $1,483,211. Besides the RRIF account value, John’s final tax return would also include unrealised capital gains from the non-registered account. And, here is the summary of John’s final tax return:
Notice that John’s final tax bill is huge, mainly because the entire RRIF account value is taxable. John’s beneficiaries will receive $2,625,001 after paying the final tax bill, as shown here.
When you compare John’s beneficiaries’ amount ($2,625,001) with Bob’s beneficiaries’ amount ($3,176,908), Bob’s beneficiaries are ahead by $551,908.
Why Bob Leapfrogged John During Retirement?
When John and Bob retired, Bob had about $646,000 less in his non-registered and TFSA accounts than John’s RRSP account. However, during retirement Bob was forced to withdraw a much higher amount from his RRIF account, which was 100% taxable. On the top of that, the higher income resulted in OAS clawback. On the other hand, Bob was in full control of his non-registered account and withdrew smaller amounts, and the withdrawals received preferential tax treatment. Besides, Bob withdrew smaller amounts from his TFSA account, while the rest kept growing tax-free. Even at death, John’s RRIF account is taxed heavily, while Bob’s non-registered account pays much lower tax.
During the retirement phase, John who saved in RRSP ended up $551,908 behind Bob, who saved in TFSA & non-registered accounts. John would have been much behind Bob, had he not started saving money in TFSA & non-registered accounts during retirement! So, clearly, RRSP is the loser, and TFSA & non-registered accounts combo is the winner.
RRSP has another big drawback — If John needs a large sum of money, say $100,000 for an emergency and withdraws it from his RRSP/RRIF account, it will push him into a higher tax bracket. In fact, he will need to withdraw a significantly higher amount ($180,000-$190,000) so that he gets $100,000 in hand after paying tax. On the other hand, Bob can withdraw any amount tax-free from his TFSA account, or even from his non-registered account by paying zero or very little tax. And, while Bob can reinvest the withdrawn amount back into his TFSA/non-registered account in future, John can’t put the amount back in his RRSP/RRIF account!
Final Thoughts
Wealth building is not just saving taxes during the working phase, rather it involves
- Managing cash flow during the working phase, and investing the savings in suitable accounts, particularly those that are flexible and tax-efficient during the retirement phase.
- Withdrawing money during the retirement phase in a tax-efficient manner so that you pay less taxes and don’t lose government benefits.
- Paying the least amount of taxes when the assets are transferred to your beneficiaries after your death.
- If you don’t plan to leave millions of dollars to your beneficiaries after your death, consider early 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.
See Related Articles
- Want to Retire? You need to plan for it…
- Earning Less than $50,000 in Canada? RRSP may not be good for you
- Stop Using RRSP if You Earn a Middle-Class Income in Canada
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