I wanted to follow-up on my first part of investing in a non-registered account that I posted last week. I mentioned how I strategically decided to invest using a non-registered account rather than topping up my RRSP account because I felt I would be in a better tax position when it came time to cashing out my investments. I was met with a few comments stating that perhaps my strategy was not valid at all and that using the RRSP was better for tax purposes. After all, I am still obligated to pay taxes, but just at a different time.
This led me to doing an investigation to determine whether using an RRSP is indeed a better alternative to investing in a non-registered account. My findings still confirmed my initial hypothesis of “It depends”.
Using A Worksheet
To help in determining whether using a non-registered account to invest, I have created a comprehensive worksheet comparing the different methods to using a non-registered investing account and an RRSP account. A copy of the spreadsheet can be accessed through the following link: Non-Registered Vs Registered Investing. Feel free to make a copy and modify it yourself if you like.
I looked at 4 distinct strategies to investing in a non-registered account versus using an RRSP account.
Taxable Non-Registered – Invest using a non-registered account where all interest income is taxable at the marginal rate on a yearly basis. No capital gains are taxed until liquidated at the end.
Non-Registered w/ RRSP Deferred – Invest using a non-registered account, but interest income from investments are put into an RRSP account to defer taxes. Can add no reinvestment of RRSP contribution, reinvest refund, or do the gross up method.
RRSP w/ Refund – Invest using an RRSP account and also reinvest the refund as well at the same time as initial investment.
RRSP w/ Gross Up – Invest using an RRSP account but gross up the amount to make it actually the pre-tax dollar value.
One of the more interesting observations that I found doing this analysis was the fact that there were varying factors that can make one methodology better than the other. It wasn’t consistent that investing using an RRSP was better than a non-registered account even with the tax free compounding.
There were a few assumptions that were made with my research. I didn’t account for a slower withdrawal of funds from an RRSP but considered a one time liquidation event of all assets. In realistic terms, this probably wouldn’t happen. Most individuals will withdraw their RRSP at a much slower rate or even at the minimum requirements specified by the government, but for the purposes of my experiment it still provides valid observations. Hopefully a few more iterations of the spreadsheet will allow me to model a better use case.
So what can one say about using a non-registered account versus an RRSP account? Let’s take a look.
- Being super conservative doesn’t help when investing in an RRSP.One interesting observation was actually taking the capital gains on an annual basis down to 0%. This models a super conservative investor who would refuse to buy any equities of any sort and sticks to a pure money market or GIC investment strategy. The one surprising thing about this strategy was that for someone in a low income bracket that stays in a low income bracket when retiring this strategy doesn’t actually pay off.
- An RRSP is terrible for pensionersThis shouldn’t be a surprise. If you put money away at a lower tax bracket and end up moving up to a higher tax bracket in the future, the RRSP is absolutely devastating. Those with defined pensions that plan to retire with 80% or more of their final income earning years are better off investing in a non-registered account rather than an RRSP where the higher tax bracket will eventually take out a huge chunk of your capital gains.
- An RRSP hurts you when you make big gainsMany of us can probably only imagine having a portfolio bigger than one million dollars. The fact is, if you achieve huge capital gains in your RRSP, you could be in for a big surprise when trying to cash it all out. The problem is that taking money out puts you in a higher tax bracket. Even if you were making nothing, the mandatory, minimum 4% RIFF withdrawal from RRSPs will push you up the tax brackets.
- RRSP helps middle income earners expecting to drop in income bracketsA majority of people will fall into this category because savings rates are so low right now in Canada. Having an RRSP will help immensely for moderately risky investors that earn a middling income but plan to make little or no income in retirement. The tax deferral strategy works the best here because the amount of taxes paid on withdrawals in retirement will be smaller than income tax paid when working.
- Re-investing your tax refund is extremely importantWhere using the hybrid approach really starts to pull ahead of any traditional method of investing is if the tax refund is put to good use. This means that taking the tax break you get from investing the interest income earned on a non-registered portfolio ends up making a large difference in the final outcome. If you use the gross-up methodology on top of investing using an RRSP and non-registered account then the difference between that methodology and the RRSP only approach is negligible. Why use a hybrid approach? Your money is more liquid. And much easier to access.
What’s best for you? It really depends what you own personal financial goals are. Take time to play around with the spreadsheet and play out some different scenarios. You might even surprise yourself in terms of what strategy best fits your investment style. Feel free to make a copy of the spreadsheet and make adjustments for yourself. I’m open to taking comments and plan on improving future iterations to better reflect real life withdrawal scenarios and inflation as well.