Here’s why investing in an RRSP does make sense for many Canadians

Let me try to un-muddy the waters by suggesting that RRSPs are likely the best way for many Canadians to save for retirement. After all, an RRSP, just like a tax-free savings account (TFSA), allows us to earn effectively tax-free investment income. And, no, that’s not a typo: tax free, not merely tax deferred.

But if you go back to basics, and really think about what’s happening with an RRSP contribution, you will soon realize the investment return on your net RRSP contribution is mathematically equivalent to the tax-free return you could achieve with a TFSA, ignoring, for now, changes in tax rates. And, provided the time horizon is long enough, RRSPs can beat non-registered investing even if your marginal tax rate is higher in the year of withdrawal than it was when you contributed.

If Sarah wants to contribute $1,000 of her income to a TFSA, she first needs to pay tax at her marginal rate of 30 per cent on that income, leaving her with $700 to contribute. Using a five-per-cent annual rate of return, her TFSA will grow to $1,857 at the end of 20 years, and, because it’s in a TFSA, the entire $1,857 can then be withdrawn tax free. Her after-tax rate of return of five per cent is, naturally, equivalent to her pre-tax rate of return because the funds are withdrawn tax free.

Applying the same annual rate of return of five per cent over the next 20 years, with no annual taxation, Sarah will be able to accumulate an RRSP worth $2,653. But, alas, not all the RRSP funds are hers to spend. The piper must be paid. When Sarah withdraws the $2,653 from her RRSP, and assuming her marginal tax rate is still 30 per cent, she will pay $796 in tax, netting her $1,857 after tax from her RRSP. This is equivalent to a five-per-cent annual after-tax rate of return on her $700 net initial investment ($1,000 contribution less $300 in deferred taxes on that initial investment).

Now, if Sarah instead invests that $1,000 in a non-registered investment account, she will first need to pay tax, leaving her with $700 to invest. If this $700 earns five-per-cent income annually that’s taxed at a rate of 30 per cent, her non-registered account at the end of 20 years will be worth only $1,393 — significantly less than the $1,857 in her TFSA or RRSP.

These examples clearly show that both an RRSP and TFSA will beat a non-registered account if your tax rate today is the same as the tax rate in the future. If, however, your future tax rate is lower than it was in the year of contribution, you will get an additional advantage when using the RRSP because you can deduct your contribution at a high rate, but pay tax at a lower rate when you take it out. Conversely, if your tax rate is low now, but expected to be higher in the future, then the TFSA will produce the better result.