Why a non-registered margin account is better than an RRSP

Taxes

*See Disclaimer*

RRSPs are awesome when you are trying to reduce your tax payable while you are working. I get it. I am tempted every year to top up my contributions so I don’t have to pay as much tax on my income. 

RRSPs will entice you with concepts such as:

1. The growth is tax-free within the account

2. You can subtract your contributions from your regular earned income

These seem like an advantage over a non-registered investment account such as a dividend bearing stock in a margin account..

But there is one thing you have to remember: You pay taxes when you withdraw any money from an RRSP at regular income rates. This is how the government ensures you pay taxes for your whole life, not just your working years. 

Concept 1 “The growth is tax free”

A Margin account with a good dividend paying stock also grows “tax free” until you sell it. There is no taxes due on “appreciation of value” unless you sell the stock. Then you will only be paying tax on 50% OF THE CAPITAL GAINS. 

Concept 2 “ You can subtract your contributions from you regular income”

This is pretty awesome, I must admit. Everyone likes to get a tax refund. But what do you do with a tax refund? Re-invest it? 

I you re-invest the tax refund back into your RRSP that would be great. 

“Can I see a show of hands how many of you re-invest your tax refunds?”

Crickets..

That’s what I thought. 

Opportunity cost.

That tax refund money sat in the government coffers doing nothing for you until they sent it back to you. This could be well over a year before you get that back from an RRSP contribution you made last year. 

If you invested in a dividend bearing investment you would be seeing a return, and compounding right away. You money will be working for you and making money from money ASAP. It is also there if you need it right away. The stock market and other investment vehicles can change quickly and unpredictably so it would be great to be able to pivot and take advantage of new opportunities as they appear.  

Back to Taxes

RRSP accounts are not “tax-free” they are “tax deferred”. You will pay tax when you use them for anything and it will be taxed as personal income, one of the highest tax rates there is. 

Now, if you are a very high earner, contributing to RRSPs might still be a good idea as you will be enjoying the tax break at the highest marginal income tax rate and perhaps when you withdraw your income level will be lower, putting you in a lower tax bracket.

Federal Income Tax Canada

2020 Federal income tax brackets*	2020 Federal income tax rates
$48,535 or less	15%
$48,535 to $97,069	20.5%
$97,069 to $150,473	26%
$150,473 to $214,368	29%
More than $214,368	33%
* These amounts are adjusted for inflation and other factors in each tax year.

From the chart above, You could be getting back 33% of your contributions and then paying 15% when you withdraw. This is cool, but it is limiting, especially if you enjoy a higher standard of living. 

Also, your RRSP nest-egg will be depleted faster than a non-registered account as you have to adjust your withdrawals for the tax burden.

e.g. If I want to withdraw $10,000 to go on a vacation

Margin - I withdraw $10,000 - I may need to pay tax on 50% of the portion that is considered capital gains. That is dependant upon how much I consider return of capital. 

or..

I BORROW $10,000 from the margin account. Then the dividends pay it back. I still receive dividends on the full amount and I pay no tax on the money I withdrew. My nest egg never shrinks.

Or..

RRSP - I need to withdraw almost $15,000 in order to have $10,000 in my pocket. This will reduce your nest egg considerably faster than a margin account. 

Borrowing

Some people find it incredible when they find out you can borrow from your RRSP to get a first mortgage or finance your existing mortgage. This is cool unless you take into consideration all of the limitations and regulations involved. You can only do so much in a certain way, if you play nice with the CMHC. 

If you borrow from your margin account you can do whatever you want. You are free to finance anything you wish. If you invest that money, the interest is tax deductible. You are your own bank.

Capital gains tax 

Capital gains tax is awesome because you only pay tax on 50% of your capital gains. So iff you invested $100000 and it grew to $300000 you could withdraw it and you would pay tax on:

300000

-100000 initial investment

=200000

50% of 200000 is 100000

You would be taxed on $100,000 of income even though you withdrew $300,000 ($23,884 if this was your only source of income)

After tax amount = $276,116

If you withdraw 300000 from an RRSP you would be taxed for 300000 of income, OUCH ($109,637)

After tax amount = $190,363

..a difference of $85,753!

For US citizens

I don’t know very much about the US tax system but I can tell you that capital gains are still taxed much more favourably than regular income. You also have to contend with short term and long term capital gains, but in the context of a retirement plan, long term capital gains apply most of the time. Since I tend to lean towards not touching your principle anyways, capital gains tax really isn’t an issue until you die. 

Dividends

Of course, I have spoken before about how dividends are taxed very favourably. Dividends are considered “after tax” profit distributions from corporations. So the income tax the corporation already paid is subtracted from your tax rate. 

E.g. if the corporation paid 18% tax on income and gives you the remainder as a distribution or dividend, you would pay your nominal tax rate LESS 18%. This is a simplification of course but the principle is accurate.

If you made $100000 in dividends and this was your only source of income you would pay:

Tax= 7,665

After tax amount = $92,335

..and if you split the dividend income with your spouse, you would pay almost no tax.

Control

A margin account is totally in your control. You buy and sell the stocks and pay a very small commission on each transaction. There are no fees, unless you are buying mutual finds. A good ETF is always an option. 

Collateral

You can use your margin balance as collateral for getting other types of loans. If you have money in a LIRA, for example, you cannot use it as it is locked in. 

Death and Taxes

When you die, your estate is taxed as if you sold everything in the year that you died. If your fortune is in the form of RRSPs it will be taxed at personal income tax rates BEFORE your beneficiarys inherit your wealth. If it is a non-registered account, it will only be subject to capital gains taxes, which will leave a lot more to your loved ones.

The Money Shot

Of course, my most passionate argument is to NEVER touch the principle. You leave your nest-egg intact and let it grow. You live off of the dividends it produces. This way you ensure money for life, and a favourable tax rate forever. If you want to learn more about this strategy. Check out my books or courses. They lay out a step-by-step plan to create this type of scenario that anyone can follow, no matter what your income level. 

As a final word, I think RRSPs (and ROTH IRA, 401K for you US folks) are great if you are not confortable with investing in general and are risk adverse. As well, if your employer offers a matched RRSP savings plan of some sort  you would be very wise to participate to the maximum. I believe that investing in registered plans is WAY better than doing nothing and that is always the key to success. Do SOMETHING. Learn as you go. 

Full disclosure - I have BOTH RRSPs and non-registered investments. I use each for different things and it works for me. The key is to know what your options are. 

Thanks

*Disclaimer* - I am not a tax expert, nor am I qualified to give tax advice. These are just my opinions and as much, may be biased and or completely wrong. Do not make serious financial decisions without consulting a real expert.