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Tax Deduction + Sheltered Growth = More Savings
The chart to the right illustrates these two tax advantages. It compares a $5,000 RSP contribution made at the start of each year to a similar amount invested without tax sheltering. We assumed a marginal tax rate of 50% and a 6% return on both investments. Here’s how they did after 30 years:
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RSP
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$419,008
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Unsheltered investment
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$245,013
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Difference
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$173,995
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Remember, though, that each $5,000 RSP contribution generates a tax deduction. That’s worth as much as $2,500, which could also be invested. We assumed it takes 12 months to actually receive that tax refund, and then invested it outside the RSP. It earns the same 6% as the RSP, but with no sheltering. That reduces the after-tax return to 3%. This builds an additional $116,439 over our 30-year savings period. Adding that to the difference above, we see that in this example the combined effects of the RSP tax advantages would put you ahead by more than $290,000!
Of course, RSP withdrawals are added to your income for the year and taxed accordingly. But those withdrawals will probably occur after you retire, when your income and marginal tax rate are likely to be lower. Also, you will probably spread your withdrawals, and the tax bite, over many years. Still, let’s examine the worst-case scenario.
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Calculating the RSP Advantage
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RSP
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Unsheltered investment
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Difference
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Value after 30 years
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$419,008
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$245,013
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-$
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Tax due
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-209,504
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Already paid
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-$
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Net value after tax
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209,504
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245,013
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$35,509
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Tax refunds invested
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116,439
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0
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-$
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Total
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$325 943
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$245 013
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$80 930
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Suppose you had to cash out the entire RSP in one year and pay 50% tax on its full value.
Collapsing the RSP in one year still leaves $209,504 after tax. Plus, you would have the $116,439 of invested tax refunds. So, even in an implausible worst-case scenario, the RSP still wins by more than $80,000!
RSP tax deferral and long-term compounding enable even modest contributions to become a sizeable retirement nest egg. This explains why RSP savings can consistently grow in real terms while unsheltered investments often do not.
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RSP vs. Regular investment
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“Normally, people are advised to pay annual RSP administration fees directly instead of having them deducted from the plan. That keeps the maximum compounding on a tax-free basis. Consider reversing that when you are about to start tapping the RSP for income. Having the fees deducted from the plan is the same as a tax-free withdrawal.“
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