Registered retirement savings plans (RRSPs) are a very useful tool for accumulating savings for retirement. Within prescribed limits (currently the lesser of 18% of earned income and $22,000), contributions to RRSPs are tax deductible and income can be accumulated tax-free in the RRSP. Many Canadians have taken advantage of this tool and now hold significant sums in their RRSPs. But as Canadians reach retirement age, one drawback becomes apparent: all withdrawals from an RRSP are taxable as ordinary income even though some or all of the underlying income in the RRSP may otherwise have qualified for a lower tax rate, such as dividends and capital gains.

If an RRSP annuitant is fairly young (say, under 40), then the benefit of tax deferral, even on dividends and capital gains, likely offsets the downside of full taxation on withdrawal, since that withdrawal won’t take place for twenty-five years or more. But as an RRSP annuitant gets older, the cost of converting dividends and capital gains to ordinary income becomes greater.

Financial advisers generally recommend a balanced retirement portfolio which includes both debt and equity securities. Debt securities generate interest income which is fully taxable if earned personally. Equity securities generate dividends and/or capital gains, both of which benefit from a reduced tax rate if earned personally. So, as a general proposition, it makes sense to hold debt securities inside the RRSP and equity securities outside the RRSP, particularly as the annuitant gets closer to retirement.

The real magic of RRSPs is simply the effect of long term tax-deferred accumulation. If an RRSP annuitant starts contributing even a modest amount at an early age and does so consistently every year, it is remarkable how much money can be saved for retirement. The amount can easily be $1 million or more and, since RRSP contributions are tax deductible, the cost of saving is subsidized by the government.

Spousal RRSPs can also be a very valuable tool, especially if one spouse earns significantly more income than the other spouse. If the higher income spouse contributes to the other spouse’s RRSP, the value of the tax deduction is maximized. At the same time, the spouses can then share the retirement income at a lower combined tax rate.

In summary, Canadians can benefit from contributing early and regularly to an RRSP. In later years, however, RRSP annuitants need to guard against converting dividend and capital gains into fully taxed income by earning such income in an RRSP and then withdrawing it fairly soon afterwards.  

Next month: Investing in Unlisted Mutual Fund Trusts.