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Capital gains and dividends within and outside RRSP
August 19, 2018
12:32 pm
Loonie
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Tax credits are not attributable to RIF withdrawals per se, and it just confuses the matter to try to do so. They are attributable to total tax owing based on income from all sources. Bill might equally decide that his medical tax credits were applied against tax owing from his pension income or from non-registered investment income (incl dividends and cap gains) etc etc.
Imagining that you will have suitable medical expenses for tax credits 30 years down the road is, in any case, not a reliable way of deciding to invest in or out of RSP. It's a matter of chance.

After 20 posts above, I haven't heard a convincing argument for why one is necessarily worse off with dividends and cap gains outside an RSP.

I think everyone will have to make their own "best guess" as to a final outcome. There are many factors that will influence the result, and there is nothing in these 20 posts that addresses all of them. Picking and choosing the factors you want to include just skews the result.

August 20, 2018
11:16 am
Top It Up
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I'm seeing these calculations to be somewhat meaningless. My RRSP had both capital gains investments and dividend investments. The reasoning was quite simple - I needed a home to stash shares earned through the company stock savings initiative (rather than cash on hand - I preferred to blow the cash on hand on vacations, and such) and/or I purchased preferred shares that were paying over 5% per year while other investment options i.e. GICs were below that.

No sharp pencil required - the ultimate goal is to earn as high a return on your investments as possible and pay your taxes accordingly.

August 24, 2018
9:18 pm
Norman1
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Loonie said

After 20 posts above, I haven't heard a convincing argument for why one is necessarily worse off with dividends and cap gains outside an RSP. …

That's not surprising as that was not the argument I was making!

The points I was trying to make were the following:

  1. It is a myth that one needs to pay a lower tax rate on the RRSP withdrawals than the rate of taxes saved on the RRSP contributions to benefit from an RRSP.
  2. It is a myth that, when tax rate on withdrawals is the same as tax rate when the contributions were deducted, one is actually paying more taxes on the capital gains and dividends in an RRSP than if one had kept them outside the RRSP.
  3. It is a myth that one must be worst off when the tax rate on the withdrawals is higher than the tax rate when the RRSP contributions were deducted. I haven't found any cases where the RRSP is better when the tax on withdrawals is 5,000 bps (50%) higher. But, there are cases where the tax rate on withdrawals is as much as 1,800 bps (18%) higher and one ends up paying less taxes than if one had invested outside an RRSP.

The negative taxation of dividends in some provinces at the lower tax brackets is interesting. But, I don't think that fully offsets the taxes on the capital gains that also come with the dividend paying stocks.

August 25, 2018
6:50 am
savemoresaveoften
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Simplified illustration why capital gain inside RRSP worse than outside:

Current tax bracket: 40%
Tax bracket when withdrawing from rrsp: 20%

You only break even as RRSP withdrawal tax as income.

If ur bracket >20% during RRSP withdrawal years, you end up paying more tax on your capital gain inside rrsp vs outside.

August 25, 2018
7:50 am
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savemoresaveoften said
Simplified illustration why capital gain inside RRSP worse than outside:
  

You can knock yourself out with all the machinations, all the estimations, etc, etc, BUT what is it that you're putting in your RRSP ... cash? ... and what were you / what are you buying with that cash - 5-year 2%, 2.5%, 3% GICs - absolutely no home run in doing that.

GO with the money play and just pay the taxes.

August 25, 2018
9:25 am
Norman1
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savemoresaveoften said
Simplified illustration why capital gain inside RRSP worse than outside:

Current tax bracket: 40%
Tax bracket when withdrawing from rrsp: 20%

If ur bracket >20% during RRSP withdrawal years, you end up paying more tax on your capital gain inside rrsp vs outside.

That actually turns out to be not the case. Taxes paid on the withdrawals is not actually the net taxes paid. In the situation given, one actually ends up paying no net tax on the capital gains and never having to pay back some of the taxes saved from the RRSP contribution deduction!

In the situation you mentioned, Alice contributes $1,000 while in the 40% tax bracket. Government rebates 40% x $1,000 = $400 of the $1,000 as a result of the RRSP contribution deduction. So, she ends up with an RRSP that looks like this:

$400 Government net contribution
$600 Alice's net contribution
$1,000 Total

After capital appreciation of 100% over the years, the RRSP looks like this:

$800 Government's portion
$1,200 Alice's portion
$2,000 Total

When she withdraws the funds while in the 20% tax bracket, Alice will end up sending the government 20% x $2,000 = $400 in income taxes. She gets to keep the remaining $800 - $400 = $400 of the government's portion.

So, she ends up with $400 of the government's portion, her original $600 net investment, plus the $600 capital gains on her net investment, all tax free.

That works out to be a $400/$600 = 66⅔% tax rebate or -66⅔% tax on her $600 capital gain. In contrast, there would be a ½ x 20% = +10% tax on her capital gain had it been outside the RRSP and realized while she was in the 20% tax bracket.

August 25, 2018
10:23 am
Bill
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Norman1, when you put $1000 into your RRSP, that's your own money, the gov't refund comes months later and does not make its way into your RRSP. Maybe if your calculations reflect that we'll understand more clearly your point.

August 25, 2018
1:16 pm
AltaRed
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Bill said
Norman1, when you put $1000 into your RRSP, that's your own money, the gov't refund comes months later and does not make its way into your RRSP. Maybe if your calculations reflect that we'll understand more clearly your point.  

Actually it is not. Your 'deducted' contribution is only the 'net' of the deduction taken and the tax credit. That is the way the calculations must be done to be equitable.

August 25, 2018
2:38 pm
Norman1
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Bill said
Norman1, when you put $1000 into your RRSP, that's your own money, the gov't refund comes months later and does not make its way into your RRSP. Maybe if your calculations reflect that we'll understand more clearly your point.  

The timing of the tax refund is not material to the calculations. Alice ends up out-of-pocket $600 and control of a $1,000 RRSP, regardless of whether she had fronted $1,000 and is reimbursed $400 later or she had contributed $600 and the government immediately put in $400.

I could normalize the out-of-pocket for the RRSP to $1,000 to make it easier to compare with the case outside the RRSP.

Alice fronts a $1,666.67 contribution while in the 40% tax bracket. Government rebates 40% x $1,666.67 = $666.67. So, she ends up $1,000 out of pocket with an RRSP that looks like this:

$666.67 Government net contribution
$1,000.00 Alice's net contribution
$1,666.67 Total

After capital appreciation of 100% over the years, the RRSP becomes this:

$666.67 Net contribution Government
$666.67 Capital gains
$1,000.00 Net contribution Alice
$1,000.00 Capital gains
$3,333.34 Total

When she withdraws the funds while in the 20% tax bracket, Alice will end up sending the government 20% x $3,333.34 = $666.67 in income taxes.

Alice essentially ends up giving back the $666.67 RRSP tax refund the government originally gave her but keeps the capital gains earned in the meantime on that $666.67 refund money! sf-surprised

So, she ends up with $666.67 of the government's portion, her original $1,000 net investment, plus the $1,000 capital gains on her net investment, all tax free.

Outside an RRSP, Alice would get to keep her original $1,000 investment and only 90% of the $1,000 capital gain, after paying 20% x ½ x $1,000 = $100 of taxes on the taxable capital gain.

August 25, 2018
4:25 pm
Bill
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Thanks, Norman1, that helps, though you've muddied it a bit by altering one of the variables, i.e. changing the tax rates from 40% at time of contribution to 20% at time of withdrawal. I think if one re-does the calculations using a constant tax rate of 40% it becomes clearer.

August 25, 2018
6:02 pm
Norman1
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Sure, I can do a normalized scenario for Bob, who has a tax rate of 40% at time of RRSP contributions and at time of withdrawals. sf-smile

Bob fronts a $1,666.67 contribution while in the 40% tax bracket. Government rebates 40% x $1,666.67 = $666.67. So, he ends up $1,000 out of pocket with an RRSP that looks like this:

$666.67 Government net contribution
$1,000.00 Bob's net contribution
$1,666.67 Total

After capital appreciation of 100% over the years, the RRSP becomes this:

$666.67 Net contribution Government
$1,333.34
$666.67 Capital gains
$1,000.00 Net contribution Bob
$2,000.00
$1,000.00 Capital gains
$3,333.34 Total

When he withdraws the funds while in the 40% tax bracket, Bob will end up sending the government 40% x $3,333.34 = $1,333.34 in income taxes.

Bob essentially ends up paying back the $666.67 RRSP contribution tax refund and the $666.67 of capital gains earned on that $666.67 refund money.

So, he ends up with his original $1,000 net investment and the $1,000 capital gains on his net investment, all tax free.

Outside an RRSP, Bob would get to keep his original $1,000 investment and only 80% of the $1,000 capital gain, after paying 40% x ½ x $1,000 = $200 of taxes on the taxable capital gain.

August 26, 2018
8:33 am
Bill
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There, that clearly shows Bob ends up with $2000 with the RRSP and $1800 without, the $200 difference being the taxes on the capital gain.

August 30, 2018
8:17 am
savemoresaveoften
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So the benefit really is the RRSP contribution "gives" u a "tax refund" that one can essentially "invest" more than one can have without the refund. And the "tax benefit" is not as significant if one maintains a high income that results in similar tax bracket during withdrawal period.

August 30, 2018
1:23 pm
AltaRed
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savemoresaveoften said
So the benefit really is the RRSP contribution "gives" u a "tax refund" that one can essentially "invest" more than one can have without the refund. And the "tax benefit" is not as significant if one maintains a high income that results in similar tax bracket during withdrawal period.  

Bingo! Dead on. One of the premises of RRSPs having a tax benefit/investment advantage is the assumption that one's marginal tax rate during withdrawal is less than the weighted aggregate marginal tax rate when contributing.

For most people, this is probably the case but for those who have managed their budgets and investments well and were successful, and participating in online financial forums, chances are their MTR is not lower, at least not significantly lower, during withdrawal.

August 30, 2018
2:11 pm
Loonie
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However, it's not as straightforward as it seems because of the impact of RSP/RIF income on Age Amount tax credit, possible OAS clawback, tax relief from medical expenses, and other disentitlements that may occur in individual situations.

FYI, for those who may not be aware, in Ontario, the Age Amount, Fed plus Prov, expressed as a non-refundable tax credit, is $1355 this year. It starts getting reduced at net income of approx 37K. At incomes of $85,863 (Fed) and $71,335 (Ont), you will have lost all of the respective Age Amount Credits. Calculations on this are a bit complicated, and I find that most people never have looked at the details.

The OAS Clawback (Federal) begins at net income $75,910. By $122,843, you will have lost all of your OAS.

Net income includes gross-up on dividends and capital gains on non-registered funds.

All of this adds up and makes the simple calculations of RSP vs non-RSP unreliable as basis for decision. In general, the greatest impact will be felt by those with net incomes over about 76K - as things now stand. These people will also be the ones most likely to have lost out because their incomes are now as high as or higher than they were when they took the RSP deduction in the first place. As we age, downsize, and free up home equity, we have more non-registered income to invest, and, thus, more annual income to add to the problem.

That said, the people at the lowest income levels also will not benefit from RSPs because they lose out on GIS , nursing home subsidies, etc.
Hence, the retirement income range where the RSP might be useful is narrowed. In many cases it is also unpredictable.

None of this matters much to me personally as my contribution years are over and all my RSPs have been necessarily converted to RIFs. Thus, I am not interested in arguing the points. Interested readers can do their own calculations for their own situations. These figures and even OAS and the credits themselves will probably change over time, but I think it's fair to say that, the more RSP/RIF income you have, which you are at that point effectively locked into, the more of it you are likely to lose.

My sole purpose here is to bring these questions to people's attention. My experience in talking to people is that most aren't really aware of the details, and those who are not yet in their 70s have very little idea of all the factors that will play out when they start cashing in their RSPs.
Median income for seniors in Canada (2016) is $26,900, so I think it's safe to say that most Canadians will not benefit from RSPs.

August 31, 2018
6:19 am
savemoresaveoften
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Another way I look at it as follows:

Assume current and future tax bracket 40%, $10000 to invest before tax, 100% capital gain after X years:

Outside RRSP:
Amount to invest after tax: $6000, total including capital gain before tax= $12000
Net amount after capital gain tax = $10,800
% return = 4800/6000 = 80%

Inside RRSP:
Amount to invest: $10k, total including capital gain before tax = $20k.
Net amount after income tax = $12,000
% return = 10000/12000 = 83.3%

For those who does well and expect to have high income post retirement, the ultimate tax benefit of RRSP is less than what most think, especially after taking into account the withdrawal impact on OAS, GIS, age amount credit.

Obviously RRSP is a fabulous vehicle that encourages one to save, and it should be maximized whenever one can afford it. Its just unfortunate when someone does well, one ends up paying high tax "forever"...

September 4, 2018
5:19 pm
Bill
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As Loonie points out there are other tax factors that need to be incorporated into any calculation and thus unless you just love doing calculations involving lots of variables, as well as trying to predict the future, it's probably best just to be aware of these factors and generally try to fit them into what you think your income might be when you retire and then contribute or not accordingly. On the other hand, you can just contribute what you can and if you end up with more income in your old age than you thought you'd have, well, maybe you made a mistake but, at the end of the day, it's not really a problem.

September 6, 2018
2:57 am
Loonie
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I have found something that I think does a good chunk of the the math for us and is helpful. Figures will vary a bit by province as provincial rates differ somewhat.

This chart was put together by Ed Rempel, who is a Canadian CA and CFP. You will find a colourful chart at about the 9-minute mark in this video which shows the impact on your marginal tax rate of the clawback of the Age Amount and of OAS at various income levels. The biggest hit comes if your income goes over about 75K, in which case your marginal tax rate goes up 13 percentage points over what it would have been for the same income before age 65. So, if your RSP/RIF income with deferred taxation and/or your grossed-up dividends, push you over 75K, you would be better off to have found some way to avoid them. However, if your income drops from about 120K while working to about 80K in retirement, then you would come out about even.

I can't figure out how to paste in this link as a link. When I try to do so, the result is that it goes directly to the video, as you see. If this is against the rules, perhaps someone can figure out how best to link it by showing only the URL.

September 6, 2018
7:05 am
Bill
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As we're told long-term employment at one place is no longer a reality, during the 45 or so years one can contribute many will have received refunds at all sorts of (unpredictable) different rates - from low in low-income years to high in high income years. Plus governments change rates during that time. How does a calculation take that into account?

September 6, 2018
9:36 am
Loonie
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No calculation can deal reliably with the totally unpredictable, as you know. But that does not mean all is Chaos and nothing can be figured out.
Individuals can make a calculation/estimate based on their personal situation, the occupation they are in, and their optimism. Some jobs are more durable than others. People do move forward in their lives with certain reasonable expectations for the future. Otherwise, nobody would ever buy a house or be happy to have children.
The stock market too is unpredictable but I have been assured by many on this forum that it will in due course always go up and that we should all invest in it.

However, the person who doesn't think their job prospects are good would be better advised to either not invest in RSPs or cash them in during periods of low income, possibly both.

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