RRSPs: Much Ado About Nothing?

Maximizing RRSP or IPP contributions has long been considered an obvious investment axiom. However for incorporated clients, more and more we see respected investment advisors challenging this notion. You have to be wary of rules of thumb however, and in the case of the choice of investing through an RRSP or IPP vs investing corporately there are many variables that can impact on reaching the right decision.

So what has changed, that a decision that seems like a no-brainer is now up for debate? The answer is tax rates. Corporate and personal tax rates have steadily declined in Canada over the last 25 years. In addition certain types of income such as capital gains and eligible dividends have been afforded increasingly preferential treatment.

So our choice now is between the diminished benefit of tax deductibility on the initial contribution and tax deferred growth offered by RRSPs and IPPs and access to preferential tax treatment on capital gains and dividends if we invest through a corporation.

An RRSP is essentially a black box. You get deductions for contributions into the RRSP and are taxed on what comes out. So while a capital gain earned outside an RRSP is taxed at half the regular rate, a capital gain earned within an RRSP is taxed at the full rate when it’s withdrawn. (43.7% vs 21.85% in BC in the top bracket). Likewise the 2012 rate in BC on eligible dividends is 26.11% in the top tax bracket while a dividend earned through an RRSP is taxed at the same 43.7% tax rate when withdrawn.

With respect to the deductibility of the contribution, where the client is incorporated, typically their personal taxable income would be limited to what they require to meet personal cash needs. Accordingly if they want to make an RRSP contribution, they will need to increase salary to meet this cash outflow, thereby bringing them to a tax breakeven position personally. It is the company that will get the deduction on the increased wage and that’s where the second shoe drops; the tax rate on active income below $500,000 has dropped to 13.5% and so the minor tax saving on the RRSP contribution and the deferral of tax on earnings within the plan have to go a long way to compensate for the loss of preferential tax treatment on capital gains and dividends on their investments.

Finally, with reduced corporate rates on investment income, particularly if you are able to recover refundable tax through annual dividends, the value of tax deferral is reduced. For example on an equity or mixed portfolio the tax rate is as low as 9% on investment income. Throw in that RRSP’s require earned income (salary) which is subject to CPP premiums, a costly forced retirement savings plan at best and the significant investment restrictions of RRSPs and IPPs, investing corporately starts to look pretty liberating.

The bottom line is that if you have a company earning active income below $500,000 and you plan to invest in the equity market you will be ahead of the game dispensing with the RRSP/IPP and investing through your corporation. The tax deductibility and deferred growth do not compensate for the inefficient tax treatment of capital appreciation and dividend distributions from the investments.

If instead your company is earning income over $500,000 or there is investment income you can claim a deduction against, the increased tax saving to the corporation makes the RRSP/IPP alternative viable. Finally, regardless of your corporate earnings, if your investments are restricted to income earning instruments (GIC’s and the like) there is no loss of preferential tax treatment and so investing through an RRSP or IPP will produce a superior result.

For more answers, please contact your local MNP Tax Advisor.

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