RRSPs can penalize lower-income workers

RRSPs are a great savings plan for high-income Canadians - but working stiffs can actually lose money when they retire by buying in

Analyze this: with Richard Shillington

  Like gray slushy snow and battery cables, February brings RRSP season. Print and TV advertising exalt the magic that Retirement Savings Plans (RRSPs) can do for 'Freedom 55', that promised retirement illusion which includes health, leisure, golf - or better - a sailboat. The ads don't mention the side-effects of RRSP's for low-income Canadians, however.
  I'm not disputing that RRSPs are a great savings plan, subsidized by working stiffs, for high-income Canadians who contribute while their tax rate is high, get half their contribution back as a tax refund, and take the money out at a lower tax rate. This works because tax rates for higher-income Canadians decline at retirement.
  The trend is opposite for low-income Canadians. They have a tax rate of 25% while working. At retirement their effective tax rate increases as they become eligible for a variety of benefits which are targeted based on income.
 

Seniors should try to keep their income under $30,000 (including the funds removed from the RRSP). They'll be better off than keeping the RRSP and losing half its value to reduced GIS.

  If low-income seniors have saved in an RRSP, then their eligibility for a range of income, health and social supports is reduced. For example, the Guaranteed Income Supplement (GIS), is reduced by $50 for every $100 of income, (including funds withdrawn from an RRSP).
  The combined loss of supports can actually eliminate all the value of the RRSP. The impact of RRSPs on income, health and social supports can increase the effective tax rate of low-income Canadians from the pre-retirement 25% to 50% (remember the GIS) to 75% if they pay taxes and 100% in a nursing home.
  To illustrate how this works, let's compare three retirement savings strategies. Each starts with $1,000 at age 45. The three investments are first, inside an RRSP (the tax refund is also invested), second outside an RRSP in GICs, third outside an RRSP in stocks (which earn some dividends and some capital gains).
  The funds each earn 5% per year but are taxed at different rates. At 65, the RRSP has grown to $3,538 significantly more than the funds invested outside an RRSP which are $2,088 and $2,380 respectively. But the money in the RRSP is trapped. Any funds withdrawn are subject to taxation and affects eligibility for income supports like the GIS, the rent in social housing, prescription drugs, nursing homes fees and the cost of meals on wheels and home care. In extreme cases, withdrawing $1,000 from an RRSP can cost you more than $1,000 in supports (effectively, your tax rates exceeds 100%).

	Outside an RRSP (Interest)	Outside an RRSP (Stocks)	Inside an RRSP*
Invested Amount	$ 1,000	$ 1,000	$ 1,333
Amount at 65	$ 2,088	$ 2,380	$ 3,538
Amount subject to taxation and income testing.	$ -	$ -	$ 3,538
Amount available after taxes and income testing.	$ 2,088	$ 2,380	$ 1,769**
* The tax deduction associated with the RRSP is also invested. ** Half the RRSP is lost in reduced GIS support

  What if you are in your early 60's - is it too late? Perhaps not - if you don't have a company pension and have let's say $50,000 in an RRSP, then you should consider removing it over three years. Try to keep your income under $30,000 (including the funds removed from the RRSP). You'll be better off than keeping the RRSP and losing half its value to reduced GIS.
 

Students in the lowest tax bracket - earning less than $30,000 - are better off saving outside an RRSP

  You even see advice in the media that students and other young people should start their RRSPs early - to develop a savings habit. Students in the first tax bracket - earning less than $30,000 - are better off saving outside an RRSP. If and when their income increases so that their tax rate is more like 50% (if their income is over $40,000 say) then they should roll their savings into an RRSP to take advantage of the tax advantages.
  So there are a number of lessons to be drawn and questions raised about program design and how institutions represent the interests of low-income Canadians.
  There is no organization doing for low-income Canadians what Bay Street does for a comfortable elite. That is, there is no one analyzing tax policy and its interaction with support programs, identifying inconsistencies and unintended interactions (marginal tax rates of more than 100%), publishing the results of their analysis and pressuring governments to rectify problems.
  As the policy trend continues away from universal programs and toward targeted programs, we ensnarl low-income Canadians in programs that make the escape from poverty more difficult.
  We can easily understand why the media and the financial industry does not provide investment advice appropriate to low-income Canadians - it's not in their business interest. But much present financial advice is incorrect for low-income Canadians.
  But the role of government is more disturbing. Shouldn't they design programs which reward savings - or failing that - tell Canadians that their programs can punish those who save? Naive - perhaps - but if we don't expect and indeed, demand more of the public sector then there will be no incentive to improve things.

Richard Shillington, Ph.D., is a statistician who specializes in the quantitative analysis of health, social and economic policy.

For more detailed information see www.cdhowe.org/pdf/shillington.pdf.

I have run across one financial advisor who seems to recognize the limits of RRSPs - www.rrsp.org/needrrsp.htm.

Other articles from Analyze this...

Posted: February 19, 2001

[ Front Page ]