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  The Companion Advisor: Retirement Planning
Is the RRSP dead?

With the recent reduction of the capital gains inclusion rate to 50 percent from 75 per cent, many advisors and their clients are asking themselves the question: "Is the RRSP dead?".

The problem, according to skeptics, is that funds withdrawn from an RRSP (or its successor, as RRIF) are included in income at the withdrawing annuitant's full marginal tax rate at the time of withdrawal. In addition, any withdrawals are taxed as straight income notwithstanding the fact that they may have been the result of Canadian dividends or capital gains earned inside the registered plan.

For example, if capital gains were earned inside an RRSP or RRIF, and are subsequently withdrawn by the annuitant, they are re-characterized as income. Therefore, the annuitant is taxed at full tax rates applicable to ordinary income instead of the reduced 50 per cent inclusion rate generally applicable to capital gains.

Now, let's assume that instead of contributing funds to an RRSP each year, we invest the same amount of our RRSP contribution in a non-registered (open) account which holds a mix of equity investments. Upon ultimate disposition, any profits earned on those investments would result in capital gains to the investor, taxable at only 50 per cent of the investor's marginal tax rate.

As a result, some advisors are concluding that perhaps it makes sense to stop contributing to an RRSP and instead, redirect that money towards a non-registered equity investment where the ultimate returns would be in the form of tax-advantaged capital gains as opposed to fully taxable registered plan withdrawals.

I'd like to suggest, however, that the RRSP is still the preferred investment vehicle for several reasons. First, the RRSP or RRIF offers unlimited tax deferral until the funds are withdrawn. In an RRSP or RRIF, the annuitant can choose to rebalance his or her portfolio as appropriate. If gains have been realized on some of the investments inside the registered plan, these gains remain tax sheltered as assets are reallocated from one asset class (e.g. equities) to another class (e.g. bonds). This gain is deferred indefinitely until the funds are ultimately withdrawn from the registered plan. Let's contrast that to a non-registered equity investment.

While it is true that no tax is generally payable on an equity investment until that investment is sold, how many clients are prepared to buy and hold an individual security or fund for 20 or 30 years? Such an argument, therefore, while in theory may sound great, is probably not practical in real life, as an investor may be reluctant to dispose of a property that has gone up tremendously in value because of the potential for large capital gains tax on such a rebalancing.

This may have the added effect of discouraging a reallocation of the investment mix where such a reallocation may be the appropriate thing to do for the client because their risk tolerance profile has changed as they approach retirement age.

Secondly, and most importantly, the RRSP offers a tax deduction in respect of contributions made. For example, someone in a marginal tax bracket of 45 per cent would get back $4,500 for a $10,000 RRSP contribution. If the tax refund received from making a contribution is continually reinvested annually in a non-registered account, after several years the value of this investment will more than compensate for the fact that the corresponding RRSP investment will be taxed at full marginal rates upon retirement.

Finally, the RRSP offers, for many Canadians at least, a psychological motivation to invest for their retirement on a regular basis. If investors can manage to invest at least the legal maximum RRSP contribution limit (18 per cent of their prior year's earned income - generally employment income, rental income, etc. - up to a maximum of $13,500 less any pension adjustment), then they will be a long way towards a financially healthy and secure retirement.

While we have encountered come situations where perhaps ceasing to make RRSP contributions makes the most sense, it would generally only be limited to specific cases. Factors to look at that may lead you to reach this conclusion include cases where:

You have already accumulated a significant amount of assets inside your registered plan;

You are approaching the age at which you will begin withdrawing from the plan, and

You expect to be in a higher tax bracket when withdrawing funds then you may have been in when the RRSP deduction was taken.

It is important to sit down with your financial advisor and work through the numbers to determine whether or not you should indeed stop contributing. However, in most cases, bearing in mind the factors above, I think you will find that the value of the reinvested RRSP tax deduction far outweighs the benefit of the potentially lower capital gains tax in a purely non-registered investment program.

This article first appeared in the July 2001 issue of Forum Magazine.

Jamie Golombek, CA, CPA, CFP, is Vice President, Taxation and Estate Planning at Aim Funds Management Inc. He provides internal consulting on all areas of taxation and estate planning.

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