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RRSP or TFSA with a Defined Benefit Pension?

With the Tax Free Savings Account (TFSA) introduced a couple years ago, it added quite a bit of complexity with regards to retirement planning.  To the financially savvy, the TFSA was quite the gift as it’s a powerful tool that compliments retirement planning.  One question that relates to the TFSA that I get often over email is what do when an investor has a defined benefit pension plan (DBP), should the priority be the RRSP or TFSA?

A Little Background

To take a step back for a moment, a defined benefit pension plan is a retirement package typically given to government workers which entitles them to a guaranteed monthly payment  for the remainder of their retired lives.   Providing the employee works with the employer for 25-30 years, they’d most likely be entitled to a annual pension in the range of 50-70% of the average of their best 5 years of service.  While the guaranteed payment is a great benefit, there are tax implications that should be considered for retirement planning.  Specifically, the government employees out there that save more than their pension contributions.  With the extra money, I usually suggest to pay down all debt first, but what about after all debt is paid off?  The first thought is usually to either put it in an RRSP or perhaps the new TFSA.  But which is the best choice?

TFSA vs RRSP

Both the TFSA and RRSP seem like a reasonable choice as  investment  tax shelter, but the major differences come out during retirement years especially those with a defined benefit pension.  As you most likely understand already, RRSP contributions are made with pre-tax dollars, but the government wants the money back some time along the way, which is why RRSP withdrawals are added to income that tax year and taxed at marginal tax rates.  The TFSA, on the other hand, works in reverse.  That is, TFSA contributions are made with after-tax dollars, but withdrawals can be made tax free.

During retirement years, the goal is to keep taxable income as low as possible because of the various clawbacks of seniors benefits as incomes rise.  These clawbacks include guaranteed income supplement (DBP recipients will likely get this clawed back anyways), age amount, and old age security.  There are a few methods of reducing  taxable income during retirement among the most effective is perhaps pension/income splitting.

As mentioned, RRSP withdrawals are considered taxable income, thus in addition to paying tax, the added income can have adverse affects on seniors benefits.  TFSA withdrawals are considered tax free with the added strength of not affecting seniors benefits which is the reason why I believe that government employees with DBP’s should utilize TFSA’s before RRSP’s.    First, the RRSP withdrawal when added to the DBP income, will result in the RRSP withdrawal owing relatively high tax.  Remember, the goal of the RRSP is to contribute when taxes are high, and withdraw when taxes are lower.  Second, as mentioned, the added income can negatively impact seniors benefits.  For example, the old age security clawback starts at the income threshold of approximately $66,700 for 2010.

Final Thoughts

In conclusion,  for those with defined benefit pension plans with expectations of full benefits during retirement, it may be a wise tax strategy to go with contributing to a TFSA before an RRSP.  TFSA withdrawals are tax free and do not test seniors benefits which means you may end up with more money in your pocket.

Here is more information on seniors clawbacks.







27 Comments, Comment or Ping

  1. Hey FT,

    Good post, the question one can ask themselves is will taxes be higher or lower in the future? If you live in any province that has HST you know the answer. Or talk to your parents or grandparents to get a trend where taxes are going. Also, look at the age amount line 301 at 65 you get an extra $6408 tax credit, but the clawback starts at just over $32,000! So the TFSA is a better choice.

    The problem is the TFSA limit is small. For some people they can go over this limit doing the same thing with a different vehicle. I sent you an e-mail to start a conversion regarding a book on this.

  2. 2. Echo

    My plan is to retire at 55, melt down my RRSP for the next 10 years, and then collect my DBP income (which will have been reduced due to my early retirement). I will still have my TFSA which holds dividend paying stocks, and I will withdraw the dividends to supplement my income.

    I contributed to my RRSP for 10 years, but have since changed careers to a job with a DBP. Now I no longer contribute to my RRSP, just the TFSA.

  3. 3. Emily

    Great post FT! This article was exactly what I was looking for. Another thought though, what about 2 income, 2 DBPs. We together make 120k/yr and pay high taxes. I am loading up into RRSPs to help with this. I was planning to pay into RRSP for approximately 5 years and then stop. One of the reasons for this is I am hoping to go on parental leave between now and then and when I did this last time I contibuted to RRSPs and owed $5000 in taxes at the end of the year. So this time I will really max out my contributions to avoid that hit. Also, I figure with the tax refunds, it can put us in a better overall position to tackle debt and or our other savings accounts. Thoughts?

  4. 4. Marianne O

    It’s important to note that there is often very little RRSP contribution room available anyway, for people who are paying into defined benefit plans.

    I’m currently paying into a DBP plan, and using what little RRSP contribution room I have to build a spousal RRSP for my husband. He has no pension plan so this is an essential item for him. In the meantime I enjoy a tax break as the higher income earner.

    We’ll also be using TFSAs as we free up money from child care & mortgage payments, but for now the DBP and spousal RRSP are all we can manage.

  5. Great post. There is no question in my mind, that if you know your retirement income will be fairly high, then the TFSA is likely as good or better than the RRSP.

    Another question would be – if you have a good pension, why are you saving anything at all??

  6. 6. Robert

    Because at any time, the company you work for could put an end to your pension. Don’t depend on it too much.

  7. 7. A.Rajah

    Good post. Like one of the other posters said if you have defined benefit pension then you will not usually have much contribution room unless you had carry forward from prior years.

    I think it also depends in the situation. If you joined the defined benefit plan later in life then you may want to contribute RRSP first (provided you have carry forward room) before TFSA. It also depends on what other income you will be receiving/ planning to receive during your retirment.

  8. 8. PuddleJumper

    Thx FT. I’ve never been one to use RRSPs and have decided to use my money elsewhere (a home purchase that became a Rental Property that I recently got out of all together). Being a DBPer I glad to hear that the RRSP decision worked was good from another point of view. I’ve just started reading lately and am trying to educate myself on all that you and the other contributors have put in. Are there any other nuances that a DBPer should be aware of?

  9. 9. alexander45

    It is actually a very complicated task to figure out which is more beneficial, because it depends on a huge number of variables that differ province to province.

    See this CD Howe document for an in-depth analysis, and look at the charts at the end to see which income ranges work best for each province for RRSP vs TFSA.

    For those of us with a long time until retirement, and so no guarantee that tax regimes will be the same, it is really a crap shoot

    http://www.cdhowe.org/pdf/ebrief_91.pdf

  10. 10. ITS

    You should write an article about what are some TFSA options. I have 10K sitting pretty in an ING savings account earning 1.5% interest.

    I am really STICKING it to the GOVT by not paying tax on 150 bucks a year. Woo-hoo!

  11. 11. Emily

    Just to be clear, I have around $25000 contribution room for this year, which won’t all be used, not even close. I am 26 … so I am thinking the 5 years is realistic and I don’t find will hurt in the longrun. If anything will help us set up our tax situtaion more effectively within that time.

  12. @emily – how much debt do you have? What are the balances and the rates?

    @ITS, check out this article on Tax-Free Savings Account (TFSA) – How should we use it?

    @alexander, I don’t think the article talks about seniors clawbacks which is the biggest advantage of the TFSA for those with relatively high income during senior years (ie. those with dbp).

  13. Excellent post (as always) :)

    I have a definined government pension too and am very happy that they have introduced the TFSA as a tax sheltered vehicle to plunker down money.

    The available amount to contribute to an RRSP is lower if you have a pension as well. I definitely agree that a TFSA is numero uno and if you have extra money you can put it in an RRSP, I think RRSP’s can still be a good idea with those who have pensions because you never know if you need to go part time to help raise kids, or not work because of job loss, or take a break for a few years etc.

  14. 14. Sampson

    Call me lazy, but that is the main reason I continue to max out my RRSP AND TFSA despite having a pretty good DBP.

    For me, the extra savings means I will be able to take an early retirement despite having significantly reduced pension payouts (due to the few number of years I will have worked under the DBP). I’ve done a bit of investigating, and any retirement take at 50 or young (i.e. only 20-25 years vested in the DBP) results in quite low pension payouts.

    Who knows what my future will bring and how eager I will be to work, but I know early retirement, either full or partial is something I would like to have the option of doing.

  15. 15. bob

    FT,

    Yes, the CD Howe document does talk about seniors clawback. In fact, it includes all kinds of different clawbacks (WITB, Seniors, Health Benefit Plateaus, EI & CPP maximums, Salses TAx Credit clawbacks, Property & Sales Tax credit claw back Health Premium thresholds, EI refunds, etc. and a whole lot more.) in its calculation of “Marginal Effective Tax Rate”.

    There is a lot more to it than simply the seniors clawback.

  16. 16. Mel

    I was fortunate to begin working for the gov just before my 25th birthday. I have a nice DBP that makes me feel excited about retiring at the age of 55 with a full pension.
    I contribute to a TFSA, as advice from Gail Vaz Oxlade mirrors that if your article (well written!)

    I have just $1600 left in an RRSP that I started contributing to when I was in my early twenties and just began working. The financial advisor charges me $50 a year to maintain it so I am thinking about taking the tax hit and closing it off and putting that in my children’s RESP, so at least I will have the government contribution to the RESP.

  17. @sampson, good point. So if you work your required amount for full pension 30 years, but take your last 5 years off before pension payouts start, do they still take the best 5 years for their calculation?

    @bob, yes you are right, I’ll have to take a closer look at the article.

  18. 18. JFG

    I just find it amazing the amount of people not using tax strategies. RRSP is tax DEFERRED, TFSA is tax free. No brainer to me, as I do not need the tax savings of the RRSP.

    Also, ITS, you can have any investment in a TFSA. From Savings account to Mutual Funds to Stock and more. You should try it for investing, instead of saving. Always amazes me that people haggle over half a percentage point.

  19. 19. Miguel

    I have a DBP, still 20 years from retiring at 55 though, and I plan on continuing to use my limited RRSP room. With the return I’ll get each year, I’ll use the proceeds to invest in my TFSA (or keep the RRSP contribution going). So why not have both??

  20. @Miguel, if you have the cash then go for it! Do you have any debt? If so, then you may be better off paying down debt b4 RRSP if you’re confident in your DBP.

  21. 21. Maltese

    Just for clarification, it’s not just government employees who have DBPs. Many large companies and banks also offer them.

    In general though, I found your article to be informative. It’s too bad that TFSAs weren’t created years ago so that us older folks could have taken greater advantage of them. But, better late than never as we will be able to make use of TFSAs in the future.

    Are you aware that income from RDSPs also do not impact senior’s benefits? I’ve seen very little written on this topic so perhaps it would be a good one for you to tackle in the future.

  22. 22. Miguel

    @FT, tough decisions always re: debt or savings. We do have a mortgage @ prime -0.65, but investments are sure to pay back much more than this in dividends alone atm. So, overall, I think savings in this environment is the more sure-fire way to go! If interest rates start to increase significantly, then re-evaluation would be needed….

  23. 23. Future Money-Bags

    Only 10% of Canadians maximize their RRSP contributions each year.
    I believe there is over 600billion in unused contribution room. I don’t see why more people are not taking advantage of this.

    I will be starting one in December, I don’t have tonnes of room as I am fairly young, but by putting in $10,000 I will get a nice $2500 tax refund to put back in. Than compound interest and a few worthy investments, and it will be very worth it.

  24. @Future Money-Bags,

    If you are getting only 25% back and have limited cash flow your best idea is go for the TFSA. Remember any gains you make CRA is your partner. If you do a great job saving you will be taxed at a much higher rate than 25% when you retire.

    Since most people do not do, or understand taxes or how the tax system works… getting a “tax refund” is a common mistake. You may want to re-read FT comments on OAS, age amount etc. Also, the trend for the government is to pay you much less for CPP payments the government have made major changes to CPP already.

    cheers,

    Brian

  25. 25. Raj

    Hi FT,

    To your question in Point 17 above, I believe different companies do it differently. For example, I’m in a DB plan with a non-govt organization; On retirement, they take in the best 5 years income of the last 10 years prior to retirement to come up with the pension income.

    Another aspect to this is inflation protection. For example, my DB plan is not indexed for inflation.

    Thanks for the informative article.

  26. 26. Future Money-Bags

    @Brian
    Well I do not have a pension, nor do I ever plan to have one.
    If I were to contribute $10,000 to my RRSP this year, I would indeed get $2,000 (roughly) in return, as long as I remain in the 20% marginal tax bracket, correct? I would than put my $2k return into my RRSP the following year, and keep the unused contribution room for later years when my tax rate is above 35%.
    I believe it is very important to start your RRSPS early on to take advantage of the ‘rule of 72′. This means that the more doubling periods that are in my life, the more my money will double until the age in which I retire. “The most powerful force in the universe is compound Interest”.

    I have small investments going into my TFSA using DCA, to take advantage of all the highs and lows of the stocks.

    PS. Just because I am only in the 20% tax bracket, no reason to be so quick to assume I have any sort of limited cash flow, or that I know nothing about how taxes work. I also do not intend to rely on CPP or OAP from the government when I retire, that is why I save over 50% of every penny I earn.

    I come to MDJ to learn more things that I do not fully understand, so if I have came off on the side of not understanding what you have messaged me, than I would be quite happy to learn something from you :)

  27. 27. RENE

    RC
    I”m retired now, and receiving a small amount of DBP. I do received CPP too.My problem is every year end i still have. to paying Taxes. Since, my RRSP contribution is still not max. I take the full advantage of contributing to avoid paying more taxes each year. I don’t know if this is the right way since I’m retired now. will I better be off contributing to TFSA? and just pay the taxes that I owe every year?. OH! just to let you know, there’s very little tax deduction being deducted on both Plan,because I do need all the money that is left to survived.Am I doing the right thing? please help.

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