If you are lucky enough to have a company RRSP and receive a year end bonus or commission payment, this question can pose quite the dilemma. When we are told about this option, it sounds like a no brainer. Invest in my retirement AND beat the tax man? Sign me up!
But, as with most decisions in this financial world, things aren’t quite so simple. And what seems like the right decision now can actually cost you substantially in the long run.
Let’s look into this scenario in a bit more detail:
We’ll start with our hypothetical employees, John and Mary. Both make a solid salary of $ 65,000 /year, and both are receiving a $ 5,000 bonus for exceptional performance. John think’s he’ll beat the tax man this year, and he plans to put his entire bonus into his company sponsored RRSP. By contributing through payroll, he is able to avoid Income taxes that would otherwise be levied on his earnings.
(As a note: other statutory deductions are charged no matter the course of action. For the purpose of this example, we will ignore them since they are the same in both scenarios.)
Mary, on the other hand, must be an avid BusinessMinded reader. She takes her bonus in cash, and therefore her employer deducts income tax (Federal and Provincial). This cash she invests in her own RRSP, and she dips a little into savings or takes a short-term loan to make sure she is also investing the same $5,000.
So far, the situation looks like this:
John looks like he's ahead at this stage. They both invested the same $5,000, but Mary paid $1,500 in tax and therefore had to borrow $1,500 to make sure she invested the same amount. But, it's tax time. And that is where the playing field levels out.
John has paid tax on his salary of $65,000, while Mary has paid tax on her salary and bonus, for a total Gross income of $70,000. John's RRSP contributions have already been considered in his tax payments, so when he files he reports income of 70,000, and RRSP contributions deducted from income of 5,000. This leaves his taxable net income of 65,000. Since John only paid income tax based on 65,000, his tax return is 0.
Mary on the other hand, has paid tax on the full 70,000 that she earned. But she also invested 5,000 into her RRSP, giving her a taxable income of 65,000. She has therefore overpaid her income taxes, and can expect to receive a tax refund! At her marginal tax rate of 30%, Mary can expect to receive a tax refund of (70,000 - 65,000) * 30% = 1,500. This money she uses to replace her savings or pay off her loan. At this stage John and Mary seem to be on equal footing.
But there's a catch. John has a typical company RRSP, maybe even a bit better than most, with only 2% management fees. Mary invested her RRSP in the same portfolio with a low cost provider, and only pays 0.75% management fees.
At an annual return of 7%, Mary will outperform John by $389 in only 5 years, on this single investment. Take that timeline out to 25 years, and John will have only 75% of what Mary has saved. This could be the difference of retiring or still working.
Important note! We did not take into consideration an employer RRSP match here. If one was available, the best option is to take full advantage of the matching contributions, and then put the rest in your lower cost (fees) RRSP portfolio.
And now, armed with this new knowledge, you are prepared to make the best investments in your future!