Personal Finance

Should my wife draw down her RRSP?

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  • Feb 12th, 2019 8:28 pm
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mathishard wrote:
Feb 9th, 2019 12:39 pm
So we just found out that she was approved for the disability tax credit, which means we can open up an RDSP for her. The plan now is to draw down the RRSP by around 10k a year and move it over to the RDSP, so she can get the bonds from the government and the tax free growth. If I understand correctly, the RDSP withdrawals will only be taxed on the portion that is growth from her deposits, and that income will not be counted against OAS. Does this plan make sense?
I'm not familiar with the RDSP, but from what I briefly read online, putting money into the RDSP is a no brainer. If you have the ability to do so, you should definitely do it. It seems that the amount of benefits are based on how much family income you make. (https://www.rdsp.com/about/what-is-it/). I'm not sure how old your wife is, but her age plays a roll in the RDSP. If she's older than 50, there might be some mild penalties if she starts to withdraw at age 60.

The benefit should not affect any other government programs like OAS or anything else, it seems to be independent.

I didn't immediately see information about withdrawals and how they are taxed, regardless the RDSP is a better vehicle than a RRSP because of the govt. grants/bonds.

It appears your family income is too high, if it's above $91,831, then you don't really get a lot of the benefit. Still worthwhile though. You might have to play around with your salary numbers and see if it's worth it to put more money into the RDSP right away depending on how much "bonus" the government gives you. if you are getting 3-1 on your money, then I would put MORE into the RDSP right away.
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bubak wrote:
Jan 23rd, 2019 8:41 am
Age matters.

RRSPs give you two things: effectively tax-free compounding, like a TFSA, plus tax rate arbitrage. In this kind of situation, the tax rate arbitrage favours withdrawing, but you are losing the tax-free compounding. That tax-free compounding is very valuable when you're in your 20s, but much less valuable when you're closer to retirement, say in your 50s.
jethrobones2 wrote:
Jan 23rd, 2019 10:40 am
This is the correct answer. If she withdraws right now in lowest tax bracket she will win the tax rate arbitrage gain, once. But now her investments are outside an RRSP and will not grow with tax free compounding which can have tremendous long term effects. Age and time horizon matter. A longer time horizon would favour keeping more in RRSP for compounding tax free growth.

Your wife should also look into an RDSP. They are fact/situation specific but could potentially be very beneficial.
Can you ELI5, of what value is the 'tax-free compounding'? Suppose you start with 10k in an RRSP and 10k in a non-registered account. Suppose both gain value over time to be worth 100k each. When the RRSP is withdrawn, 100k is going to be taxed at your marginal tax rate, vs the non-registered account which will be taxed at the capital gains rate, which would result in an overall less tax liability. What am I missing?
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Altera wrote:
Feb 10th, 2019 10:38 pm
Can you ELI5, of what value is the 'tax-free compounding'? Suppose you start with 10k in an RRSP and 10k in a non-registered account. Suppose both gain value over time to be worth 100k each. When the RRSP is withdrawn, 100k is going to be taxed at your marginal tax rate, vs the non-registered account which will be taxed at the capital gains rate, which would result in an overall less tax liability. What am I missing?
You are missing a fundamental difference: $10k in an RRSP is not equal to $10k non-registered.

Say your marginal tax rate is, as an example, 40%.
In that case, $10k in an RRSP should be compared with $6k non registered.
Suppose both gain value over time to be worth 10 times more, $100k in the RRSP vs. $60k non-registered.
Say that at withdrawal time, your MTR is still 40% (most likely it will be lower).
After paying $40k in taxes, your $100k RRSP becomes $60k after tax.
After paying $10.8k in taxes ($54k x 0.5 x 0.4), your $60k non-registered becomes $49.2 after tax.
Any annual taxable income generated in the interim makes the comparison even worse for the non-registered alternative.
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Altera wrote:
Feb 10th, 2019 10:38 pm
Can you ELI5, of what value is the 'tax-free compounding'? Suppose you start with 10k in an RRSP and 10k in a non-registered account. Suppose both gain value over time to be worth 100k each. When the RRSP is withdrawn, 100k is going to be taxed at your marginal tax rate, vs the non-registered account which will be taxed at the capital gains rate, which would result in an overall less tax liability. What am I missing?
You can buy & sell as often as you want in the RRSP without generating taxes owed. The only way to avoid taxes in the non-registered account is to never sell.
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Altera wrote:
Feb 10th, 2019 10:38 pm
Can you ELI5, of what value is the 'tax-free compounding'? Suppose you start with 10k in an RRSP and 10k in a non-registered account. Suppose both gain value over time to be worth 100k each. When the RRSP is withdrawn, 100k is going to be taxed at your marginal tax rate, vs the non-registered account which will be taxed at the capital gains rate, which would result in an overall less tax liability. What am I missing?
Say you invest $100 at a 10% return. After a year, you get $10.

How much do you earn in 40 years? 40*$10 = $400?

No. In the second year, you have $110, so your 10% earns you $11, not $10. In the third year, you earn not $10, not $11, but $12.10. That's compounding. If you do the arithmetic, after 40 years, you've earned not $400, but $4,425.93. Compounding is great.

Now say your tax rate is 50%, so half your earnings go to taxes. After 40 years, how much have you earned? 50% of $4,425.93 = $2,212.96? No. After 1 year, you have $105, so in the second year, you only earn $10.50 instead of $11, and half of that $10.50 goes to taxes, so you're left earning $5.25, which is less than half of the $11 you would have earned without taxes. Now do the math for 40 years. You earn not $4,425.93, not $2,212.96, but $604.00. Even though your tax rate was "only" 50%, your total earnings were reduced by a whopping 86%! So compounding is much more powerful when it's tax-free.

When you go to the store and buy something, hand over a $20, and get $10 in change, how much did you pay for your purchase? $10, right? Not $20.

When you put $100 into an RRSP, you get $50 back as a tax refund, so you only really paid in $50. Your account statement says that you have $100 in there, but that's misleading: part of that $100 and the returns that it will earn really belongs to the government, and you will have to pay it as taxes when you withdraw. Whenever I look at the numbers on my RRSP statement, I always discount them by my tax rate to get the real numbers. That makes the numbers smaller, but it makes them accurate.

So to put $100 into your RRSP, you really need to put in $200 and get $100 back in change (tax refund). Your RRSP statement will say $200, but you really only have $100 in there. The other $100 and all the growth on it really belongs to the government, so you shouldn't think of it as yours. But you do have $100 in there that's really yours.

After 40 years, the $200 in the RRSP grows to $9,051.85. You withdraw it and the government gets 50%, so you're left with $4,525.93. Subtract the original $100, and you get $4,425.93. That's the tax-free compounded amount that we calculated earlier. Not $604.00, not $2,212.96, but $4,425.93, the full tax-free compounded return.

Now say the year you're 5, your tax rate is 50% and then the year you're 6, your tax rate is 20%, so you deposit your $200, get your $100 refund, then the next year you withdraw $220 and only pay $44 in taxes on it, so you've turned $200 into $276. That's nice, but you've used up $200 of your lifetime contribution room that you can never get back, and which could have been used to make $4,400. When you're 25, you might come to regret the decision that you made back when you were 5.

That's why age matters. If you're 65 instead of 5, you only have a few years of compounding left, so the tax-free compounding is worth a lot less, and it's probably a better idea to just take the $76. The point is that it's a tradeoff between two competing benefits, and you need to do the math with your numbers to evaluate the two. You should use more realistic numbers than 10% and 50% for the growth rate and the tax rate. I picked those as round numbers because you said ELI5.
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bubak wrote:
Feb 11th, 2019 7:21 pm
Say you invest $100 at a 10% return. After a year, you get $10.

How much do you earn in 40 years? 40*$10 = $400?

No. In the second year, you have $110, so your 10% earns you $11, not $10. In the third year, you earn not $10, not $11, but $12.10. That's compounding. If you do the arithmetic, after 40 years, you've earned not $400, but $4,425.93. Compounding is great.

Now say your tax rate is 50%, so half your earnings go to taxes. After 40 years, how much have you earned? 50% of $4,425.93 = $2,212.96? No. After 1 year, you have $105, so in the second year, you only earn $10.50 instead of $11, and half of that $10.50 goes to taxes, so you're left earning $5.25, which is less than half of the $11 you would have earned without taxes. Now do the math for 40 years. You earn not $4,425.93, not $2,212.96, but $604.00. Even though your tax rate was "only" 50%, your total earnings were reduced by a whopping 86%! So compounding is much more powerful when it's tax-free.

When you go to the store and buy something, hand over a $20, and get $10 in change, how much did you pay for your purchase? $10, right? Not $20.

When you put $100 into an RRSP, you get $50 back as a tax refund, so you only really paid in $50. Your account statement says that you have $100 in there, but that's misleading: part of that $100 and the returns that it will earn really belongs to the government, and you will have to pay it as taxes when you withdraw. Whenever I look at the numbers on my RRSP statement, I always discount them by my tax rate to get the real numbers. That makes the numbers smaller, but it makes them accurate.

So to put $100 into your RRSP, you really need to put in $200 and get $100 back in change (tax refund). Your RRSP statement will say $200, but you really only have $100 in there. The other $100 and all the growth on it really belongs to the government, so you shouldn't think of it as yours. But you do have $100 in there that's really yours.

After 40 years, the $200 in the RRSP grows to $9,051.85. You withdraw it and the government gets 50%, so you're left with $4,525.93. Subtract the original $100, and you get $4,425.93. That's the tax-free compounded amount that we calculated earlier. Not $604.00, not $2,212.96, but $4,425.93, the full tax-free compounded return.

Now say the year you're 5, your tax rate is 50% and then the year you're 6, your tax rate is 20%, so you deposit your $200, get your $100 refund, then the next year you withdraw $220 and only pay $44 in taxes on it, so you've turned $200 into $276. That's nice, but you've used up $200 of your lifetime contribution room that you can never get back, and which could have been used to make $4,400. When you're 25, you might come to regret the decision that you made back when you were 5.

That's why age matters. If you're 65 instead of 5, you only have a few years of compounding left, so the tax-free compounding is worth a lot less, and it's probably a better idea to just take the $76. The point is that it's a tradeoff between two competing benefits, and you need to do the math with your numbers to evaluate the two. You should use more realistic numbers than 10% and 50% for the growth rate and the tax rate. I picked those as round numbers because you said ELI5.
Excellent explanation. I was missing the point of pre-tax and post-tax dollars.
[OP]
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Oct 20, 2018
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Not that any of you are incorrect about RRSPs, etc., but I just want to point out that my wife's income is effectively going to be $0, so she's not really going to have any advantage in terms of growth within an RRSP vs. in an unregistered account. Anyway, we're going to open an RDSP for her and with draw about $10k/year from the RRSP and move it into the RDSP, which also offer tax-free growth. I'll do it as late in the year as we can, so we can get the refund for the withholding tax she'll pay as quickly as possible.

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