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The RSP Conundrum... Should I invest in an RSP or not?
By Randy PerramRetirement Savings Plans (RSP) have long been recognized as an essential retirement planning vehicle. However, the value of this retirement planning vehicle is sometimes questioned by individuals who wonder if they are better off to invest outside of an RSP. This article will examine the various factors that should be considered when looking at investing within or outside of an RSP.
RSP-related Concerns
The Canadian government introduced the Retirement Savings Plan (RSP) in 1957 to encourage individuals to save for their retirement. By investing in an RSP, an individual can deduct the amount of the RSP contribution from their taxable income, up to their annual RSP deduction limit, thereby lowering the amount of taxes paid. In addition, the RSP can grow on a tax-deferred basis—the investment income is not subject to tax until such time as it is withdrawn from the RSP or its successor, the Retirement Income Fund (RIF).
Since funds within an RSP have never been subject to income tax, all amounts withdrawn from the RSP/RIF are fully taxable as income in the year the withdrawal is made. One concern, especially for those who have accumulated significant sums in their RSP’s, is that the entire amount of the RSP/RIF will be included as income in the year of death unless the RSP/RIF can be transferred to a surviving spouse or a financially-dependent child or grandchild. This could mean that a significant portion of the RSP/RIF would be taxed at the highest marginal tax rate, which would not have otherwise been the case.
It is this concern of losing a significant portion of their RSP/RIF to taxes, coupled with the fact that capital gains outside of an RSP have only a 50% inclusion rate (i.e., much lower tax rate) that have caused many individuals to reconsider investing in an RSP. Many individuals wonder if they would be better off to invest outside of an RSP, especially if they intend to invest in equities (stocks), compared to making similar investments inside an RSP.
To analyze this question with respect to your own situation, you must look to the various factors that affect the net after-tax values of your RSP investment. These factors include your marginal tax rate, investment horizon, rate of return on investment, type of investment (e.g., bonds/stock), and the current value of your RSP portfolio. Each of these factors is discussed in greater detail below.
Marginal Tax Rate
Your marginal tax rate in each of the following periods can affect your decision to invest in an RSP: 1) at the time of your RSP contribution, 2) throughout the period of your RSP investment, and 3) at the time amounts are withdrawn from your RSP/RIF.
MARGINAL TAX RATE AT CONTRIBUTION TIME
Your marginal tax rate at the time of your RSP contribution is perhaps the most important factor in determining whether to invest in an RSP or not. This is because the tax savings from your RSP deduction can provide you with more capital up front to earn additional income than if you were to invest outside of an RSP.
Consider an individual in a 40% marginal tax rate who has $1,000 to invest. If this individual invests this amount outside of an RSP, only $1,000 will be available to earn income. If the individual invests the $1,000 in an RSP, up to $400 in tax savings can be received which can also be invested. This $400 could be invested outside of the RSP or could be used to make another RSP contribution. In this case, the individual will have up to $1,400 available to earn income.
The higher your marginal tax rate at the time of your RSP contribution, the larger your tax saving, and the more up front capital you will have to earn income. The additional capital generated by the tax savings will generally make investing in an RSP a better choice for you if you are currently taxed at the highest marginal tax rate.
MARGINAL TAX RATE DURING
THE RSP INVESTMENT PERIOD
Your marginal tax rate throughout the period of the RSP investment can also influence your decision to contribute to an RSP. In general, the higher your marginal tax rate during this period, the better it is for you to contribute to an RSP. This is because the benefit of tax sheltering
Income inside your RSP increases as your marginal tax rate increases.
MARGINAL TAX RATE AT WITHDRAWAL
Your marginal tax rate at the times of your withdrawal from your RSP/RIF can also affect your decision to contribute to an RSP since amounts withdrawn from an RSP/RIF are included in your income in the year of your withdrawal. For most working people, contributing to an RSP makes sense since they will likely be in a lower marginal tax rate when they retire. By making RSP contributions now, they will not only benefit from the ability to defer tax on the income earned inside the RSP, but also pay less tax on the principal amount.
For example, consider a working individual currently in a 40% marginal tax rate. Assume that this individual will be in a 30% marginal tax rate during his retirement due to a decrease in income. On a $1,000 of income, this individual will pay 40% or $400 in taxes today. The individual could defer paying taxes on this amount by making an RSP contribution of $1,000 today. If the $1,000 is withdrawn from the RSP/RIF during his retirement, then only $300 of taxes would be paid. By making the RSP contribution, he will not only benefit from the tax deferred growth inside the RSP, but also pays less tax on the $1000.
If you are currently in a lower marginal tax rate the advantage of investing in an RSP may be less obvious, particularly if you will be in a higher marginal tax rate at the time the investment is withdrawn from the RSP/RIF. In this case, whether you will be better off investing in an RSP will depend on other factors such as your investment time horizon, your rate of return on investment, and also the type of the investment you choose.
Investment TIME Horizon
One of the key benefits of contributing to an RSP is the ability to earn tax-deferred income. The advantage of compounding growth of an RSP increases considerably the longer the investment is held inside the RSP. This is illustrated in Table 1 below, which compares the investment growth in net after-tax dollars, of a $1,000 investment in an RSP versus outside of an RSP assuming an annual 6% return (fully taxable in the non-registered account each year) and a marginal tax rate of 40% every year.
Table 1
Years RSP(A) Non-Registered (B) Difference (A-B) 10 $475 $424 $51 20 $1,324 $1,029 $295 30 $2,846 $1,889 $957
Table 1 illustrates that the overall difference in the net after-tax growth of a $1,000 investment inside an RSP versus outside of an RSP increases dramatically with time.
Rate of Return
Your rate of return can also influence your decision to contribute to an RSP. In general, the higher your rate of return, the greater your benefit of investing in an RSP will be. To illustrate this point, consider the previous example except that instead of using an annual rate of return of 6%, an annual rate of return of 8% is used. The result is shown in Table 2 below.
Table 2
Years RSP(A) Non-Registered (B) Difference (A-B) 10 $695 $598 $97 20 $2,197 $1,554 $643 30 $5,438 $3,082 $2,356
By increasing the annual rate of return by 2%, the difference in the net after-tax growth of a $1,000 RSP investment versus a non-registered investment also increases over the 10, 20, and 30 year periods.
Type of Investment
Different tax rates are applied to different types of investment income. Interest income is taxed at your full marginal tax rate while capital gains are only taxed at one-half of your marginal tax rate.
Dividend income, from Canadian corporations, also receives a favourable income tax treatment.
Since interest income is taxed at a higher rate than capital gains or dividends from Canadian corporations, interest income, such as GICs and bonds, should be purchased inside the RSP whenever possible. This way, the interest income earned can be sheltered from tax. Common stocks and preferred shares also benefit from the tax sheltering capabilities of an RSP to a lesser extent.
Some commentators advocate purchasing common shares as an alternative to investing in an RSP. Since common shares often provide little, if any, dividend distributions, common shares can offer tax deferral benefits similar to an RSP in that the shares are only taxed when sold. In addition, unlike RSP income, which is fully taxable, only 50% of the gains from the sale of common stocks are subject to tax. Any losses arising from the sale of a common stock can also be used to offset capital gains, while capital losses realized inside an RSP can’t be used to offset capital gains generated inside or outside of an RSP.
This investment strategy may make sense for you if investing in common shares is consistent with your investment objective and risk tolerance. To benefit from this strategy, you would also need to be in a low marginal tax rate, and either expect to be in a significantly higher marginal tax rate at a future time, or have already accumulated a large RSP portfolio.
Another RSP alternative which is sometimes mentioned is to invest in a universal life insurance policy. Investment earnings within such a policy can occur on a tax-deferred basis and if the earnings are paid out as death benefits, they can be received tax-free by the beneficiary.
Comparing the merits of investing in an RSP versus investing in a universal life policy is beyond the scope of this article; however, investing in a universal life policy can be very beneficial for those who require insurance coverage and also wish to leave a larger estate to their beneficiaries.
Value of Existing RSP Portfolio
A common concern among RSP investors is the possibility that they may have to pay close to half of the value of their RSP/RIF portfolio in taxes in the year of death. Current Canadian tax rules require that the value of your RSP/RIF portfolio be included in your income in the year of your death (since you have never paid tax on these amounts yet) unless your RSP/RIF can be transferred to your spouse or your financially-dependent child or grandchild. This could potentially cause an individual who would generally be in the lowest tax bracket to be in the highest tax bracket in the year of death. As a result, some or all of the value of their RSP/RIF portfolio may then be subject to tax at a higher rate than it would otherwise have been.
The possibility of paying tax at a higher or the highest marginal tax rate may discourage low income individuals who have large RSP portfolios (or significant unrealized capital gains in their non-registered portfolios since the capital gains could be deemed to be realized at death) and no qualified beneficiaries, from investing in an RSP.
RSP vs. Non-RSP Investment Calculations
Your Advisor can help you calculate, based on given assumptions, the net after-tax values of a $1,000 investment in an RSP versus invested outside of an RSP. Ask your Advisor for assistance in determining what’s right for you.
Conclusion
As with most financial planning questions, determining whether you will be better off investing within your RSP or outside of your RSP will depend on your specific situation and several financial assumptions. However, the following general observations can be noted:
1) If your current marginal tax rate remains the same (or decreases) throughout the period of the RSP investment, you will generally be better off to invest in an RSP regardless of the type of investment you choose or the rate of return on your investment.
2) You may be better off to invest outside of your RSP if you are seeking to invest in common stocks and you are currently in the lowest marginal tax rate level, but are expecting to be in a higher marginal tax rate level in the future.
3) For all other situations, the decision to invest in or outside of an RSP will depend on your current and future marginal tax rates, your investment horizon, and also the type of investment you choose.
Note: The above information is based on the current and proposed tax law in effect as of the date of this article. The article is for information purposes only and should not be construed as offering tax or legal advice. Individuals should consult with qualified tax and legal advisors before taking any action based upon the information contained in this article.