Is the RRSP best tax shelter for retirement?

The deadline for RRSP contributions that are deductible on your 2009 income tax return is March 1, 2010. A lot of people are now faced with a decision about whether to make a contribution.

Try thinking about your decision this way: The reason you save and invest a portion of today's income is to make it grow so you can use it for future goals. Those goals might be short term, like a vacation or a new car, or they might be long-term goals.

One long-term goal common to most employed people is to achieve financial independence -- the time when your investments can support you, so your decision to work can be by choice, not out of need.

Achieving this means committing a certain percentage of your current income to long-term savings. This article is about how to do that most efficiently, for the goal of achieving financial independence.

Over the long term, tax efficiency is important, but making your savings commitment and decision comes first. "How badly do I want to retire, and when?" Answer this before trying to decide whether to make an RRSP contribution, just because the deadline looms.

Also remember, the RRSP decision is about deciding where to invest the money, not how. Choice of investment vehicles -- bonds, GICs, stocks, mutual funds, ETFs, or other options -- also comes later.

What I'm saying is that you need to decide on your chosen destination first, and then decide on your preferred transportation method.

As an example, if you are committed to investing $10,000 a year and your time horizon is 10 years or more, let's look at your options.

The first option is to simply invest $10,000 into a non-registered investment. That gives you $10,000 to invest, which will earn interest, dividends or capital gains, depending on how you invest it. When you want income from it, you can use the taxable investment income it is earning at the time, or you can slowly sell the investments during retirement, at which time the original invested capital comes back to you tax-free, and you pay tax on half of the future capital gains, if any.

Option 2: If you use the $10,000 to make an RRSP contribution, you save tax at your marginal tax rate, multiplied by the contribution. For example if you are in the 34.75 per cent bracket (in Manitoba, that means taxable income between $40,727 and $67,000 after deductions), then you reduce your 2009 taxes by $3,475.

This gives you tax dollars you can use to:

1) increase your total savings capacity;

2) pay down debts;

3) use for other needs; or,

4) spend wildly.

If you invest the tax saving as soon as you receive the refund, then that increases your saving capacity to $13,475 for 2010. If you have the RRSP room, you can get an additional tax reduction for the additional contribution, and so on. That's a good deal.

The investment income earned along the way is not taxable. However, every dollar you withdraw adds to your taxable income and you pay tax on it at the marginal rate applying in the year(s) you withdraw.

This also adds to your net income, which negatively affects tax credits and OAS clawback, if that ends up applying to you in retirement.

Option 3: A new one last year, put $5,000 into a TFSA (tax free savings account) and invest the other $5,000 elsewhere.

There is no tax deduction for the contribution, nor is there a tax bill when you withdraw either the original capital or the growth, and there is no annual tax on the investment income along the way.

The lower tax on withdrawal can make a huge difference to your after-tax income, and there will be no negative effect on income-tested tax credits or on OAS clawback. When I run the numbers, this can mean that $100,000 in a TFSA may be worth more to you in retirement than $150,000 in RRSP, as an example.

Unless you expect to be in a lower tax bracket in retirement than now, seriously consider the TFSA as the first priority, even though it means more tax today.

There are a lot of other considerations. Consult your financial adviser, my blog or other sources for more points of view.

David Christianson is a fee-for-service financial planner and portfolio manager, whose team at Wellington West Total Wealth Management Inc. provides comprehensive financial advice and management. You can email him at dchristianson@wellwest.ca or visit his blog at www.davidchristianson.com.

Republished from the Winnipeg Free Press print edition January 22, 2010 B9