Do TSFAs and RRSPs really compete? And if so, who wins?
David Christianson, CFP, R.F.P., TEP
Happy first birthday to the Tax Free Savings Account program. How does your TFSA look as a one-year old?
Many individual TFSAs had a spectacular first year. Even invested in high-quality stocks or trust units, many grew by as much as 60%, thanks to the great timing of the market bottom in March, 2009. One account of which I am aware soared by 130%, to $11,500 by the end of the year.
None of that will happen again this year, I don’t expect, and that is not the point of this article. RRSP contributions made into those same investments at the same time grew by the same amount.
Instead, we are here today to briefly say happy birthday, then focus on how the TFSA and the RRSP might best co-exist.
If you have personal non-registered money that is earning taxable investment income, then moving that money into a TFSA is practically a no-brainer. This account shelters the investment income from tax, with no significant strings attached. (If you don’t have cash around, then it is not an obvious thing to do.) However, it does not provide a tax deduction on contribution.
Unlike the RRSP, there is no tax on the TFSA withdrawal, either of original invested capital or investment earnings and growth. Therefore, there is no risk either from early collapse, or from using your future large TFSA as a source of retirement income.
The future withdrawals will not increase your tax bill or negatively affect other government programs, like tax credits or Old Age Security.
That begs the question, should I consider a TFSA instead of an RRSP contribution, if I have limited money to invest for retirement? The reality is that many people struggle to maximize their RRSP, and do not have spare cash available to also fund a TFSA.
So, it’s an excellent question. In broad strokes, using the TFSA as a place to put your retirement investments means giving up the immediate tax refund that can be created by contributing the same amount to an RRSP. A fair comparison, therefore, must assume that you use that tax refund to add to your investment capacity right now, meaning that using an RRSP increases your savings capacity by as much as 46%, depending on your current marginal tax rate.
Does that mean that the RRSP will work much better for retirement? Surely, if you can put away 40% more money now and have that grow and compound for 20 or 30 years, that nest egg will be much larger.
Well, let’s look at an example, using $5,000. (If you can afford to contribute more than that, then use the RRSP for the excess.) We will use a 35% marginal tax rate today, and a 28% MTR in retirement.
A $5,000 RRSP contribution and tax deduction therefore saves $1,750 in immediate taxes. If you add these two amounts together, then $6,750 can go into the RRSP this year, compared to $5,000 into the TFSA.
If you do each for 30 years and earn 7% (by investing in good quality equities), my old HP 12C calculator tells me the TFSA grows to about $434,000 and the RRSP to about to $586,000. As expected, advantage RRSP, but here is where it gets fun.
Let’s assume we withdraw 5% in retirement, or $21,700 from the TFSA and $29,300 from the RRSP. You get to keep and spend the $21,700, as it is not taxable.
On the RRSP income, you must pay 28% tax, or $8,204, leaving you $21,096 to spend. Hmmm. Advantage, TFSA.
Another consideration is that the RRSP income is likely to cause the loss or reduction of income-tested tax credits or other programs, like the Age Credit and Medical Expense Credit, which means an effective 25% additional penalty. To the extent that your income is above $66,733 after age 65, then you will also lose $3 of OAS for each $1 of taxable income.
Have your tax professional prepare an analysis based on your current tax bracket and estimated income in retirement. Each person’s situation is unique.
After several such analyses, I now give the TFSA much more respect as a one-year old than I did when it was a newborn. Adding to that respect is our continuous tax planning with retired people, where we work very hard each year to prepare an income plan for them that will minimize current taxes, maximize credits and avoid OAS clawback, while still trying to use the assets in their RRSPs.
It is a continuous challenge, but I guess that’s why we get paid! The TFSA gives us another weapon in the arsenal, and one to which we are paying close attention.
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David Christianson is a fee-for-service financial planner and portfolio manager, whose team at Wellington West Total Wealth Management Inc. provides comprehensive financial advice and management. You can e-mail him at dchristianson@wellwest.ca or visit his blog at www.davidchristianson.com.