I’ve read a lot of bad takes on RRSP contributions and tax rates over the years. One that stands out is the argument that you should avoid RRSP contributions entirely, and focus instead on investing in your TFSA and (gasp) your non-registered account. This idea tends to come from wealthy retired folks who are upset that their minimum mandatory RRIF withdrawals lead to higher taxes and potential OAS clawbacks. They also seem to forget about the tax deduction generated from their RRSP contributions and the tax-sheltered growth they enjoyed for many years leading up to retirement.
I’m hoping to dispel the notion of an RRSP disadvantage by reframing the way we think about RRSP contributions, RRIF withdrawals, and tax rates. Here’s what I’m thinking:
Most reasonable RRSP versus TFSA comparisons say that it’s best for high income earners to prioritize their RRSP contributions first, while lower income earners should prioritize their TFSA contributions first.
The advantage goes to the RRSP when you can contribute at a higher marginal tax rate and then withdraw at a lower marginal tax rate, while the advantage goes to the TFSA when you contribute at a lower rate and withdraw (tax free) at a higher rate.
If your tax rate in your contribution years is the same as in your withdrawal years then there’s no advantage to prioritizing either account. They’re mirror images of each other.
Related: The next tax bracket myth
This comparison focuses on marginal tax rates. But is this the correct way to frame the discussion?
Marginal Tax Rate vs. Average Tax Rate
Isn’t it fair to say that an RRSP contribution always gives the contributor a tax deduction based on their top marginal tax rate (assuming the deduction is claimed that year)?
But when you look at retirement withdrawals, shouldn’t we focus on the average tax rate and not the marginal tax rate?
An example is Mr. Jones, an Alberta resident with a salary of $97,000 – giving him a marginal tax rate of 30.50% and an average tax rate of 23.59%
If Mr. Jones contributes $10,000 to his RRSP he will reduce his taxable income to $87,000 and get tax relief of $3,050 ($10,000 x 30.5%).
Fast forward to retirement, where Mr. Jones has taxable income of $60,000 from various income sources, including a defined benefit pension, CPP, OAS, and his $10,000 minimum mandatory RRIF withdrawal.
The range of income in each tax bracket can be quite broad. With $60,000 in taxable income, Mr. Jones is still at a 30.5% marginal tax rate, but his average tax rate is just 19.33%. That’s right, he pays just $11,596 in taxes for the year.
Conventional thinking about RRSPs and marginal tax rates would tell us that Mr. Jones should be indifferent about contributing to an RRSP in his working years because he’ll end up in the same marginal tax bracket in retirement.
But when we consider all of our retirement income sources, why do we treat the RRSP/RRIF withdrawals as the last dollars of income taken (at the top marginal rate) instead of, say, income from CPP or OAS or from a defined benefit pension? Why would Mr. Jones’ $10,000 RRIF withdrawal be taxed at 30.5% when it’s his average tax rate that matters?
Put another way, let’s say Mr. Jones asked his financial institution to withhold 30% tax on his $10,000 RRIF withdrawal. Wouldn’t he get a tax refund after filing his taxes revealed an average tax rate of 19.33% (assuming other income sources were taxed appropriately)?
What if we assume zero withholding taxes were taken from the defined benefit pension, CPP, OAS, and minimum RRIF withdrawal (of $10,000)? This taxpayer simply owes $11,596 at tax time (ignoring other deductions for simplicity). Why would we think the RRIF withdrawal is taxed at 30.5%? And, if we did, then which income stream is counted first and gets the basic personal amount treatment (yay, my CPP and OAS are tax-free!)?
The point is, all of your income streams converge into one pile of income and they’re taxed at your average tax rate.
Finally, I get that RRSP/RRIF withdrawals are often subjective – as in you can choose when and how much to take prior to RRIF conversion. You can also take more than the minimum from your RRIF, in which case your marginal tax rate may come into play when considering additional withdrawals.
But a lot of the pushback against contributing to your RRSP in the first place seems to come from high income retirees who argue that the minimum RRIF withdrawals are causing high tax rates and OAS clawbacks. So it seems like they’re not taking any more than the mandatory minimum – which makes the RRIF withdrawal a fixed amount similar to CPP, OAS, and the defined benefit pension.
Final Thoughts
I get there is a lot of nuance to this discussion, but my basic argument boils down to this:
It’s helpful to think about your RRSP contribution as always receiving a tax deduction at your top marginal rate, and to think about your RRSP/RRIF withdrawals as being taxed at your average tax rate (especially if you’re just taking minimum RRIF withdrawals). This strengthens the advantage of contributing to your RRSP and hopefully dispels any bad notions about avoiding RRSPs due to tax implications.
PS – this doesn’t even touch on the other RRSP advantages such as qualifying for additional Canada Child Benefit for parents with young children by lowering their net family income, or the ability for retirees to split RRIF withdrawal income after age 65 to save on taxes.
Bottom line: While there are situations when contributing to an RRSP is not a good idea (such as for low income earners who may qualify for GIS), most Canadians should be taking advantage of their RRSP contribution room for immediate tax relief, long-term tax-sheltered growth, and flexible retirement withdrawals at their average tax rate.
Do-it-yourself investors face a number of behavioural hurdles when it comes to building an investment portfolio.
We look to past performance to guide our future investing decisions – ignoring evidence that yesterday’s winners often become tomorrow’s losers.
We disregard decades of research that shows how low cost investing through passive index funds beats active stock picking strategies over the long-term.
We build needlessly complicated portfolios when simple, automatically rebalancing solutions exist.
We tend to panic when markets go down or sideways for a period of time, instead of accepting that volatility is the price of admission.
Put up your hand if you added a technology tilt to your portfolio after the NASDAQ returned more than 48% in 2020. Same goes for cryptocurrency or the latest meme stock.
Who increased their equity allocation after markets roared back to life last spring?
Which part of your portfolio did you tinker with to help hedge against higher inflation?
We can’t help ourselves.
I’m here to remind you to embrace the simplicity that comes from holding a single asset allocation ETF (or a robo advisor portfolio for those who don’t want to self-direct).
You’ll own 13,000 global stocks and 17,000 bonds inside of just one product. For that incredible simplicity and diversification investors pay as little as 0.20% MER.
Asset allocation ETFs help deal with a number of behavioural limitations. One, because they roll-up 4-7 underlying ETFs into one product, investors are less inclined to fuss over an asset class or region that is underperforming at the moment. Two, they automatically rebalance daily with new fund flows to maintain their target asset mix. That saves DIY investors from trying to exercise their own judgement and decision making.
Related: Why indexing doesn’t mean settling for average returns.
Some investors have a hard time embracing the simplicity of a single fund solution. I’ve seen portfolios that hold multiple asset allocation ETFs from different fund providers, which defeats the purpose of a single-ticket solution.
Maybe they’re trying to avoid putting all their eggs in one basket, but it’s helpful to remember that these products actually contain 4-7 underlying ETFs that represent thousands of stocks and bonds from around the world. It’s a big basket!
I get it. Investing doesn’t seem like it should be this easy. But it can be. Open a brokerage account, open the appropriate account types, fund the account(s), and purchase a single, risk appropriate asset allocation ETF. Then do nothing.
Your future self will thank you for generating the most reliable investment outcome. Heck, your current self will thank you for saving time and stress over managing your portfolio. Win-win.
This Week’s Recap:
We reached the halfway mark of 2021 and I shared my mid-year net worth update.
A reminder to check out my last weekend reading post where I shared some juicy new welcome bonuses from American Express. I’m well on my way to building back my Aeroplan balance.
From the archives: Why you should stop asking $3 questions and start asking $30,000 questions.
Thanks to Darcy Keith and Larry MacDonald for including my takes on leveraged investing in their Globe and Mail piece (subs):
“It reminds me of 2006-07 when the Smith Manoeuvre was getting a lot of uptake. Investors see strong market returns plus low interest rates and feel like they can dial up their risk with a leveraged loan,” Mr. Engen said. “Of course, the financial crisis put an end to that idea.
“Now a new batch of investors are looking at leveraged investing as a way to juice their already strong recent returns. I don’t think it’s a good idea. I’d ask anyone who is seriously considering a leveraged investment loan how they felt in March, 2020, when their non-leveraged investments were down 34 per cent and it looked like we were in for a prolonged bear market,” he said.
Promo of the Week:
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Weekend Reading:
For those of you who aren’t interested in travel rewards, our friends at Credit Card Genius have compiled the best cash back credit card offers right now.
Great piece by A Wealth of Common Sense blogger Ben Carlson about how doing nothing is hard work.
Collaborative Fund’s Morgan Housel explains the casualties of perfection:
“Cash is an inefficient drag during bull markets and as valuable as oxygen during bear markets. Leverage is the most efficient way to maximize your balance sheet, and the easiest way to lose everything. Concentration is the best way to maximize returns, but diversification is the best way to increase the odds of owning a company capable of delivering returns. On and on, if you’re honest with yourself you’ll see that a little inefficiency is the ideal spot to be in.”
Read why young Canadians are dropping their do-nothing financial advisors salespeople for DIY investing.
Retiring from full-time work leaves a void. How will you fill it?
How is it okay that we’re meant to work a 9-5 for 40+ years and then retire? Maybe we’ve been bamboozled.
Jason Heath explains what you need to know if your retirement is riding on your rental property income.
Here’s Ben Carlson again with 16 unbelievable facts about the markets.
Professor Moshe Milevsky explains the difference between retirement and decumulation using an excellent example from Australia.
Some young clients fear missing out, while older ones may be sitting on unexpected gold mines. Here’s how advisors are rethinking their approaches with clients looking to get into, and out of, the housing market.
My Own Advisor Mark Seed looks at the role of an Executor when it comes to estate planning.
Finally, Millionaire Teacher Andrew Hallam explains how to become a digital nomad. Sounds tempting!
Have a great weekend, everyone!
Our net worth surpassed the million-dollar mark at the end of last year. It was a goal I had been chasing since I began sharing net worth updates back in 2012. So, what now?
Life is about the journey, not the destination. Along the path to $1M I built a side-business that helped accelerate our financial goals. I quit my day job at the end of 2019 and turned that side business into a full-time entrepreneurial career.
That decision changed our lives, not just from an earnings perspective but also in terms of lifestyle. We caught the travel bug after an epic 32-day trip to the UK and Ireland, and plan to do more world travel again soon.
I’m motivated by big, audacious goals. That’s why I’ve targeted a net worth of $2M by the end of 2025. I’ll continue sharing these updates twice a year to hold myself accountable and to be completely transparent with my readers. Hopefully you find some inspiration for your own journey. If not, well, it’s always interesting to take a look under the hood at someone’s financial situation.
The first half of this year has gone incredibly well, financially speaking. Our business revenue in six months alone is 2x greater than my final annual salary at my day job. I plan to intentionally earn less money in the back half of 2021 as health restrictions ease and we can (hopefully) travel again.
The markets continue to hit record highs and my all-equity investment portfolio is reaping the benefits. I invest in Vanguard’s VEQT across all of my accounts, and so far this year my investments are up 12.18% (30.97% year-over-year). No meme stocks or crypto for this guy. Just 13,000 global stocks doing their thing.
The bulk of our savings have gone into my wife’s TFSA and into our corporate investment account. We decided not to pay down the mortgage any faster than our current amortization schedule calls for, taking advantage of our ridiculously low variable rate of 1.45%. My thinking is that if rates tick up above 3% by the time our term is up (Sept 2023) then we might throw some extra cash at the mortgage. Our registered accounts will be completely filled and we can balance non-registered savings with more aggressive mortgage payments.
Finally, we had some landscaping work done in the backyard and bought an above ground pool from Canadian Tire as a hedge in case we couldn’t travel this summer. The kids have been in the pool non-stop, especially during this incredible heat wave.
Now, let’s look at the numbers.
Net worth update: 2021 mid-year review
Total Assets – $1,376,719
- Chequing account – $5,000
- Savings account – $85,000
- Corporate investment account – $159,777
- RRSP – $277,317
- LIRA – $184,036
- TFSA – $131,908
- RESP – $74,681
- Principal residence – $459,000
Total Liabilities – $179,756
- Mortgage – $179,756
Net worth – $1,196,963
One interesting takeaway from looking at this is our total investments are now worth more than $825,000. I’d love for this amount to reach $1M by the end of the year, but that might be a long shot. We can control our savings rate but we can’t expect markets to continue climbing at 2% per month.
Now let’s answer a few questions about the way I calculate net worth:
Credit Cards, Banking, and Investments
We funnel all of our purchases onto a couple of different rewards credit cards to earn points on our everyday spending.
Our go-to card is the Scotia Momentum Visa Infinite Card, which we use for non-Costco groceries and gas. I’m also using the HSBC World Elite MasterCard, which came with an incredible 100,000 point welcome bonus. Finally, we look for the best credit card sign-up bonuses and time our large annual spending (car and house insurance) around these offers.
Our joint chequing account is held at TD, along with our mortgage and kids’ RESPs. My wife has her own chequing and savings accounts at Tangerine. Our high interest savings account is held at EQ Bank, which pays 1.25% interest.
My RRSP and TFSA are held at the zero-commission trading platform Wealthsimple Trade. My LIRA is held at TD Direct, and the new corporate investment account is held at Questrade. My wife’s investments are held at Wealthsimple. You know all of this from my post about how I invest my own money.
RRSP / LIRA / RESP
The right way to calculate net worth is to use the same formula consistently over time to help track and achieve your financial goals.
My preferred method is to list the current value of my RRSP, LIRA, and RESP plans rather than discounting their future value to account for taxes and distributions.
I consider a net worth statement to be a snapshot of your current financial picture, so when it comes time to draw from my RRSP/LIRA and distribute the RESP to my kids, my net worth will decrease accordingly.
Principal Residence
We bought our home in 2011 for $425,000 and developed our basement a few years later, increasing its value to $450,000. The next year I bumped up the market value by 2% (which is still less than its city-assessed value), but the local real estate market has since flattened – with nothing selling in our price range – and so I’ve left the value at $459,000 for the past three years.
Final thoughts
I quit my job three months before a global pandemic shut down the economy. As health restrictions ease and we emerge from 16 months of largely stay-at-home orders, I can’t help but be excited once again for the future. To travel again and live the type of location-independent lifestyle that I had in mind in the Before Times.
My wife and I have designed a great work schedule that aims to maximize productivity during the week. But throughout the pandemic it was easy to work too much and bite off a little more than I could reasonably chew. Now we plan to dial that back to a more appropriate level that will allow us to travel and live the life we had envisioned earlier. Yes, we’ll intentionally earn less revenue so we can enjoy more leisure time.
I’ll share more about this in a future post, but with the amount we’ve been able to save and invest over the past two years I think we can dial back the work load so that we earn just enough to pay our living expenses and max out our TFSAs – and that’s it. This sort of Coast FI approach will allow us to work on our own terms and maximize our leisure pursuits.