Marylou Heenan RRC, CCS
In retirement, there’s a tax-saving strategy called “topping up to bracket.” It’s used when funds in a Registered Retirement Savings Plan (RRSP) or a Registered Retirement Income Fund (RRIF) will eventually be withdrawn when you’re in a higher tax bracket. The idea is to withdraw funds from your RRSP or RRIF in an amount that takes you to the upper limit of the marginal tax bracket you are in currently. You don’t actually need this money to support your retirement lifestyle – you invest the funds in a Tax-Free Savings Account (TFSA) or non-registered account. However, by making the withdrawals now at a lower tax rate, you save tax in the long run.
The usefulness of this strategy has led some investors to question the value of choosing an RRSP over a non-registered account. All withdrawals from an RRSP or RRIF are taxed as income at the individual’s marginal rate. But in a non-registered account, dividends and capital gains are taxed more favourably. Based on taxation upon withdrawal, should a non-registered account be the investment vehicle of choice?
Financial experts have compared the after-tax performance of RRSPs with that of non-registered investments under numerous time horizons, with model portfolios representing a variety of asset allocations – including equity-focused portfolios. RRSPs win out over non-registered accounts, provided the amount of the RRSP tax deduction is invested each year in a non-registered account.
It’s the tax advantages that are essential to RRSP performance. The ability to deduct your RRSP contribution from taxable income is a significant advantage over investing in a non-registered account. Also, an RRSP gives your investments tax-deferred compound growth. Tax deferral makes quite a difference when it comes to rebalancing. Imagine that an investor approaching retirement wants to redeem equity investments and purchase fixed-income investments. Such a move would have no tax consequences within an RRSP, but in a non-registered account could trigger considerable tax on capital gains.
RRSPs also motivate you to invest regularly since contributions provide a substantial tax deduction every year. And you’re less likely to tap into retirement savings when withdrawals are taxable, trigger withholding tax and cause loss of contribution room.
Another advantage of RRSPs over non-registered investments surfaces during retirement. Retirees age 65 and older can transfer up to 50% of RRIF income to their lower-income spouse, splitting income to reduce overall tax.
We’ve focused on RRSPs versus non-registered accounts as this comparison has been a source of debate, but TFSAs also outperform non-registered investments. Investors should maximize their RRSP and TFSA before investing in a non-registered account. With a TFSA you pay no tax on interest income, dividends or capital gains for tax-free growth within the account. And withdrawn funds are not only tax-free, they don’t affect a retiree’s eligibility for Old Age Security (OAS) benefits.
To return to where we began, topping up to bracket is simply an effective tax strategy – not a reflection of RRSP performance versus that of a non-registered account. However, there can be exceptional circumstances when an individual would be better suited choosing a non-registered account over an RRSP. Such a situation could be when an individual close to retirement invests in equities and expects to be in a higher tax bracket when withdrawing funds for retirement income.
Please talk to us if you have any questions or concerns about the way your current or future contributions are allocated among registered and non-registered investment vehicles.