Getting a tax refund is one of the main motivators for contributing to RRSPs. However, there are two main benefits of RRSPs and the tax refund is not one of them.

The benefits of RRSPs are:

  1. Tax-free growth (same as the TFSA).
  2. Tax gain or loss depending on your post-retirement tax bracket when you withdraw vs. your tax bracket now when you contribute.

Tax-free growth? Isn’t it tax-deferred growth?

A simple, but dramatic example will clarify this. Let’s say you contribute $10,000 to your RRSP, your investment doubles in one year and then you withdraw it. Assume you are in a 40% tax bracket both years.

Invested              $  6,000                ($10,000 less the $4,000 tax refund)

Withdrew            $12,000                ($20,000 RRSP less $8,000 in tax)

Gain                           100%               You doubled your money tax free.

Note that if you had invested the $6,000 in a TFSA and doubled it to $12,000, you would have been in the identical situation.

What about CRA? CRA actually invests along with you. They charge you “interest” on the tax refund equal to your rate of return on your RRSP, so they make the same return you do.

In the example, CRA gave you a refund of $4,000 and then charged you $8,000 in tax the following year. So CRA doubled its money, just like you did.

In addition to the tax-free growth, you have a significant gain if your tax bracket is lower after you retire compared to your tax bracket now. That often happens because your retirement income will probably be lower than your income now. If your post-retirement tax bracket is higher, however, perhaps because of clawbacks on government benefits, then you lose part of the benefit of the tax-free growth.

Note that the tax refund itself is not one of the two benefits of RRSPs. Of course, there are unique cases where you may need the tax refund for a specific purpose (such as an RESP contribution for your smart kids that you cannot otherwise afford).

However, the tax refund itself is not a benefit. You have to pay it back plus interest (at the rate of return of your RRSP).

In short, the benefit to you of investing in your RRSP is tax-free growth of your investment, plus or minus a gain or loss on you tax brackets now vs. after you retire.

 

Ed

3 Comments

  1. Commoncents on April 17, 2016 at 8:31 PM

    Thanks for clearing this up. I’ve seen this mistake made more than a few times.



  2. Shaun on October 14, 2020 at 3:50 PM

    To help lower the amount of taxes paid on an RRSP withdraw, I guess a strategy would be to also have non-registered investments (mutual funds / etfs). You could use the expense fee to offset the taxes due when you pull out some of the RRSPs.

    Another option could be borrowing to invest with a HELOC or something. That way you can use the interest expense as a counter to some of the RRSP withdraw taxes. Once the RRSPs are fully cashed out, you could then pay off the borrowed funds if you really wanted.



  3. Ed Rempel on October 14, 2020 at 10:05 PM

    Hi Shaun,

    Good points. You can partly offset tax on RRSP or RRIF withdrawals with other deductions, such as investment expenses from a portfolio manager or interest borrowed to invest.

    If your investment management fees are transparent and charged separately, they are usually tax deductible in a non-registered account. For example, for our clients, both our fee and our portfolio manager’s fees are tax deductible.

    This is helpful for people doing the Smith Manoeuvre to give them larger tax deductions. It’s also helpful for retirees to reduce tax on their RRIF withdrawals.

    Ed



Leave a Comment