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This simple example may, at first glance, seem counter-intuitive. After all, with the RRSP Shira is paying tax on the dividend income at her full, ordinary Alberta tax rate of 30 per cent and if she went the non-registered route, her dividend income is only taxed at a 10 per cent marginal rate on eligible dividends. But, of course, her “net” investment in a non-registered investment is lower, and thus her dividend income is lower, because she had to pay 30 per cent tax on her employment income before she could invest.
Another way to look at is that by contributing to an RRSP, you are effectively getting a 100 per cent tax-free rate of return on your net after-tax RRSP contribution. In this case, Shira’s net (after-tax) RRSP contribution was $2,100 (i.e. $3,000 X (1 – .30)), which at a five per cent return, yields $105 of effectively tax-free dividends.
Finally, I would argue that even if your tax rate is higher in the year of withdrawal (or ultimately, in the year of death) than it was in the year of contribution, you could still be better off with an RRSP than non-registered investments because the benefits of effectively tax-free compounding might actually outweigh the additional tax cost of a higher withdrawal tax rate. This, of course, will depend on your expected rate of return, the number of years of compounding available, as well as the types of investment income you might otherwise earn by saving an equivalent amount in a non-registered account.
Jamie Golombek, CPA, CA, CFP, CLU, TEP is the Managing Director, Tax & Estate Planning with CIBC Private Wealth Management in Toronto.