Generally, maxing the RRSP is the best strategy for most levels of income. The TFSA is best suited for saving for a lump sum cash call… if you anticipate a constant (inflation adjusted) after tax income in retirement, max your RRSP, then max your TFSA and if there is anything left over dump the rest into nonreg.

Using simplistic (spreadsheet) marginal or average tax rate models is not suited for this type of calculation… the complex way that investment capital (and other non-investment entities) interact with income tax over time is of primary importance for this type of analysis.

RRSP withdrawals are done at your marginal rate, not your average rate. If you are comparing TFSA to RRSP, your income when you withdraw would be the same except for the RRSP withdrawal. So, it is on top of any other income.

TFSAs as a retirement vehilce are also most beneficial to:

1. Anyone that has saved very little for retirement and has no pension plan.

2. Those that have quite a bit of retirement savings or modest savings and a
pension plan.

3. Anyone who will be in a similar tax bracket when they retire than when they are working and will not contribute 100% of their tax refunds back to RRSPs (and gross them up).

The first 2 groups would be affected by clawbacks in retirement, so they will almost definitely be in the same or a higher tax bracket when they retire than they work.

Ed

Your figures are correct. Note that the RRSP only keeps up with the TFSA when you “gross-up” your contribution. You only put $600 into the TFSA, but $1,000 into the RRSP.

If you had $600 cash, you could not put that into your RRSP to get an extra $400 tax refund. Your refund would only give you a refund of $240 ($600 x 40%).

You would need to gross-up your contribution. This means you would contribute your $600 and borrow $400 more to contribute, which would give you a full $1,000 to contribute. Then your refund would be $400, so you could pay back the $400 you borrowed.

For RRSP to keep up with RRSP, you need to gross-up your contribution every year.

As George pointed out, contributing your refunds is often hypothetical for those that always max out. This is even more true for those that gross-up their contribution every year.

Ed

RRSP withdrawals are done at your average tax rate (assuming no other retirement income), which is lower than your marginal tax rate, as David notes above.

TFSAs as a retirement vehicle are most beneficial to the following groups:

1) Low-income earners who don’t get much benefit from the deductability of RRSP contributions (and who stand to lose out from retirement benefits due to claw-backs).

2) High-income earners who want to shelter some of their non-registered portfolio.

3) Middle- and upper-income earners who also have a good pension plan and therefore have reduced RRSP contribution limits due to the pension adjustment (PA).

It should be

Say you have $1000 in pre-tax income, and your tax bracket is at %40.

In the first year you invest
TFSA = $600 ($1000 – $400 in tax)
RRSP = $1000 (no tax, no refund)

After 20 years at %5.5 compounded annually, you pull the money out at a tax rate of %40

Used PV*(1+R)^N
where PV is present value, R is the interest rate, and N is the number of investment periods.

TFSA = $1751 (no tax)
RRSP = $1751 ($2918 – $1167 tax for the withdraw at 40% tax)

Looks the same to me.
The only benefit would be if you take the money out at less than 40% tax.

For people like me (savers with maxed out RRSPs and good pensions), the TFSA is awesome as an early-retirement savings tool.

$1000 is available for both the TFSA and the RRSP. If he invests the refund, as cannon_fodder states, it balances out. However, since most folk will place funds into an RRSP and get their marginal tax rate on contribution, and only pay at their average tax rate on withdrawl. This can be about a 10 – 15% difference.

DAvid

Say you have $1000 in pre-tax income, and your tax bracket is at %40.

In the first year
TFSA = $600 ($1000 – $400 in tax)
RRSP = $1000 (no tax, spent refund)
RRSP + return = $1400 ($1000 + $400 tax refund invested immediately)

After 20 years at %5.5 compounded annually, you pull the money out at a tax rate of %40

Used PV*(1+R)^N
where PV is present value, R is the interest rate, and N is the number of investment periods.

TFSA = $1751 (no tax)
RRSP = $1751 ($2918 – $1167 tax)
RRSP + refund = $2451 ($4085 – $2451 tax)

So the results look like a tie if you spend your refund, but if you don’t the RRSP is the clear winner.

If your really want to nickel and dime it you could borrow the $400, putting $1400 in to you RRSP right from the start, getting a $560 refund (%40 tax), with a net gain of $160.

If you put the $160 in to your RRSP for the next year, and the $64 (%40 x $160) refund from that etc. etc. you gain an addition $264 from refunds after 5 years (at that point the refund is less than $1 so I stopped)

Put this in the equation and when you take the money out at the end of 20 years you have:

RRSP + invested refunds = $2875 ($4792 -$1917 in tax)

A $1875 increase from your initial $1000 vs. a $751 increase from the TFSA.

So the RRSP + invested refunds beats the TFSA by $1124, or a ratio of 2.5:1

I’m not sure what you did to calculate the outcome you did, but it obviously was in error. If the $1,000 TFSA only increases by $751 after 20 years, you’ve realised compound growth of only about 2.8% per year.

Let’s assume you are in the 40% tax bracket and your growth is 8%. You can either put in $1,000 into the TFSA and watch it grow for 20 years = $4,660.96 OR you can borrow $666.66 and add it with your $1,000 to put it in your RRSP. You will get your $666.66 back at tax refund time (which hopefully is soon after you borrow it so that interest costs are small). The way you arrive at $666.66 is simply by taking the amount of cash on hand divided by (1 – Marginal Tax Rate) and then subtracting the amount of cash on hand. In this example: [ $1,000 / (1-40%) ] – $1,000

Now, your $1,666.66 can grow at 8% over 20 years to become $7,768.23. If you take it out at 40% MTR, then the value of that $7,768.23 is, of course, $4,660.96. No advantage either way.

The question is, if you take all of that money out at once 20 years from now, will it necessarily be at a 40% MTR? Not at all! Factor inflation into it and you will see that the amount of income required to be at a 40% MTR, with all else being the same, will be much higher – probably 50% higher. Also factor in that you are retired and for many people this will mean that they actually withdraw less income than they did during their working years (especially as they close in on retirement) and they need less income. I would bet that as the aging baby boomers start retiring en masse, studies will show that retirees are withdrawing RRSP/RRIF money at a lower MTR than their contributions if they typically were able to contribute at a 40% or greater MTR.

Because GIS entitlement is an annual process, perhaps some people will determine that they are better off to take a little more money out of their RRSP’s than they need one year and contribute it to the TFSA so that the following year they can receive their CPP, OAS, and still qualify for GIS – making up any income required via TFSA withdrawals.

If your really want to nickel and dime it you could borrow the $400, putting $1400 in to you RRSP right from the start, getting a $560 refund (%40 tax), with a net gain of $160.

If you put the $160 in to your RRSP for the next year, and the $64 (%40 x $160) refund from that etc. etc. you gain an addition $264 from refunds after 5 years (at that point the refund is less than $1 so I stopped)

Put this in the equation and when you take the money out at the end of 20 years you have:

RRSP + invested refunds = $2875 ($4792 -$1917 in tax)

A $1875 increase from your initial $1000 vs. a $751 increase from the TFSA.

So the RRSP + invested refunds beats the TFSA by $1124, or a ratio of 2.5:1

The best use for most people for the TFSA would be as a retirement vehicle. It is called a savings account (as are RRSPs) and you can use it as a savings account, but the long term tax savings with that use would be very small compared to using it as a retirement vehicle.

The long term growth of your retirement nest egg should be many times higher than just a savings account.

This is especially true if you will be affected by clawbacks after you retire. For most Canadians, having a nest egg in RRSP and one in TFSA will allow very effective tax planning during retirement.

Ed

The government said that the TSFA was based on a UK program.

It sounds to me like TFSA / RRSP now gives Canadians the “IRA” / “Roth IRA” option. (Except with a 5k TFSA limit instead of an income %).

Am I on track here or is it just late?

I agree with your George. It looks like TFSA rules will be basically identical to RRSP’s, other than the tax on contributing and withdrawing. Both will not allow tax deductible loans, investment options will probably be identical, etc.

This also makes sense for all those companies administering them, since it will take almost no programming to allow an RRSP administrator to administer TFSA’s.

Ed

Good question. The $31,000 income above which you will probably be at a higher tax bracket when retiring than when working is individual. So, yes, that would be up to $62,000 for a couple is split evenly.

This is taxable income, which would include investment income. This means it only includes 50% of any capital gain, but 145% of any dividend. For this reason (and how it affects clawbacks), after 65, capital gains beat dividends.

Ed

It’s true that the rules can be changed, but I don’t think it’s likely that TFSAs will become highly used. RRSPs are an excellent way to defer taxes, yet very few people have used all their contribution room. TFSAs will help to encourage people to save more, and true savers will be the ones who benefit the most.

TFSAs could have a positive impact on the business community, as it might increase the amount of capital available for investment, especially if mutual funds and publicly-traded securities can be held in the accounts.

For now consider the creation of the TFSA, to be a political move aimed at seniors upset about the income trust situation. It is also a way for the govt to encourage saving without interfering with the monetary policy (raising interest rates), which could impact the business community.