March 1997

Capital Gains Better
Than RRSPs For Some

© Talbot Stevens

Last month's Strategy Sheet introduced how, for many Canadians, non-registered equity funds can be better than RRSPs. Now we will briefly quantify the comparison of capital gains and RRSPs.

The goal of retirement planning is to produce enough income to last until death.

Note that to be meaningful, an after-tax evaluation is essential. Before-tax analysis is often done for simplicity, but this can lead to the wrong conclusions.

To evaluate capital gains and RRSPs on an after-tax basis, we need to define and calculate the after-tax, indexed income that each strategy can produce over a desired retirement period.

The following table shows the after-tax, indexed income that $1,000 invested until retirement will produce for a ‘typical' Canadian over a ‘typical' retirement period. Specifically, the table shows the initial, after-tax income that can be withdrawn over a 20 year retirement period leaving no estate. The after-tax income increases annually with a 3% inflation rate. A 40% tax bracket and 10% investment growth is assumed both before and after retirement.

Note that the results are for a ‘typical' unregistered equity fund, NOT pure capital gains, because most people invest for capital gains using equity funds.

The overlooked human nature parameter “What do you do with the RRSP refund?” is also accounted for. The more common case where none of the RRSP refund is reinvested produces much less than when all of the refund is invested back into RRSPs.

After-tax Indexed Income from $1,000
Years Before Retirement Unregist. Equity Funds RRSP Refund 0% Inv. %Diff. from Equities RRSP, Refund 100% Inv. %Diff. from Equities
3 94 69 -27% 97 3%
5 109 84 -23% 118 8%
10 161 135 -16% 190 18%
20 362 351 -3% 492 36%
30 826 911 10% 1275 54%

From the table, several important conclusions can be made.

What you do with the RRSP refund is critical. Not reinvesting all of the RRSP refund will significantly reduce your retirement income — by the same percentage as your tax rate.

If you don't reinvest the RRSP refund and retirement is less than 20 years away, then unregistered equity funds are better than RRSPs. This is a major change from conventional thinking.

If you reinvest all of the refund, then RRSPs are better if you have at least 3 years before retirement.

Much more research in this area is necessary, especially exploring the “hidden” tax of the new seniors benefit clawback.

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