We all know that RRSP contributions can provide substantial tax relief in the year the contribution is deducted. What is often forgotten is the power of tax-free compounding that RRSP investments afford.

As Director of Tax and Estate Planning at CIBC, Jaime Golombek points out, the investment income earned within an RRSP is not merely tax-deferred. Assuming the account holder is in the same or lower tax bracket at the time of withdrawal, the investment income earned in an RRSP is actually tax-free! To prove his point, Golombek provides this example:

John’s marginal tax rate is 33%. At the beginning of the year, he can afford to invest $2,000 of his savings in an RRSP. This means he will actually contribute a total of $3,000, with the goal of generating a tax refund of $1,000.

So where does John get the extra $1,000 to fund his contribution? He borrows it temporarily, from other non-registered investments or with a loan, and pays it back as soon as he gets his tax refund. If timed properly, the duration of such a loan can be minimal, with only a small amount of interest to be paid.

Now, assuming John earns a 5% return on his $3,000 investment, his RRSP will have grown to $3,150 by December 31st. If John withdraws that $3,150 from his RRSP and he’s still in a 33% tax bracket, he would pay taxes of $1,050 and net a total of $2,100. As you’ll see below, when you compare the $100 he has netted with the $2,000 it cost him to contribute, John has realized a 5% rate of return. In other words… the income he earned was indeed completely tax-free.

The RRSP account would show a much greater advantage over the non-registered, if this example took into consideration a longer holding period, allowing the investment income earned within the RRSP to grow tax-free for many years. In that case, the final result puts the RRSP well ahead of the non-registered investment plan, regardless of the type of income earned be it interest, dividends or capital gains. Such is the “power” of compounded tax-free investment income. In some cases, depending on the total holding period, and rates of return achieved, the benefits of tax-free compounding will make the RRSP more advantageous, even if the account holder withdraws at a higher tax rate!