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TFSA vs. RRSP - Best Retirement Vehicle?
Ed Rempel, a CFP and CMA, has written another guest post on the topic of TFSA vs. RRSP's. This time, instead of writing about clawbacks, he does a direct comparison. It's a fairly lengthy (and technical) post, so you may want to get more comfortable.
“You give 100 percent in the first half of the game, and if that isn't enough, in the second half you give what's left.” – Yogi Berra
Tax Free Savings Accounts (TFSA’s) will be available in 2009. Should we be using them instead of RRSP’s to save for retirement?
The short answer is that there is not a definite answer. It will depend on your circumstances.
Since the real difference between them is the tax consequences, the answer depends on 2 key factors:
- Marginal tax rates when contributing vs. marginal tax rates when withdrawing.
- Use of the tax refund.
Key Factor 1
Most people assume that they will be in a lower tax bracket when they retire, since they will be making less income than while they are working. If this is true, that would be better for RRSP’s. In the introductory article about clawbacks on seniors, however, we saw that this is often not true.
The 3 main clawbacks on seniors are on the GIS, age credit and OAS. All of them apply to all seniors within that income bracket, so they will cost seniors real money.
The top tax bracket for non-seniors in Ontario is 46% which starts with a taxable income of $120,000. For seniors, however, when you included the clawbacks, we found that they are at a marginal tax bracket of 46% or higher if their income is either under $15,000 or over $37,000.
This $15,000 threshold below which the GIS 50% clawback applies will vary between $15-20,000. Use $20,000 if your income will include the maximum OAS (40 years in Canada at age 65) and you are single, and $15,000 if not.
This means that the only people that would be at a lower tax bracket will be those with a retirement taxable income between $15,000 (or $20,000) and $31,000. That range has only a 21% marginal tax bracket. For non-seniors, you are in a marginal tax bracket with an income over $37,000.
This means that RRSP’s have an advantage for those with working taxable incomes over $37,000 that expect to retire with an income between $15-31,000. This would apply to those with modest retirement savings, but not those with essentially no savings or to those with lots of savings.
These terms are very general, but “modest retirement savings” means something like $50,000-$150,000 when you are in your 40’s and say $250,000 to $750,000 when you will retire. These figures assume retirement is 15 to 25 years from now.
There will be all kinds of variations for different people, but there are some rules of thumb:
Key Factor 1 Winner
The winner, generally, for each is people in these categories:
RRSP
- Reasonable working income and modest retirement savings or pension.
- High working income (over $120,000).
TFSA
- Low working income (under $37,000/year).
- Reasonable or high working income with very little retirement savings or pension.
- Reasonable or high working income with generous retirement savings or pension.
Key Factor 2
If you use an RRSP, what do you do with the tax refund? Getting a tax refund is the main reason many Canadians contribute to an RRSP. How you use it is critical for the TFSA vs. RRSP battle.
Based on the work of Talbot Stevens, there are 3 options for your tax refund:
- Spend the refund.
- Reinvest the refund to your RRSP.
- “Gross-up” the tax refund.
To understand “gross-up”, let’s look at an example. If you have $10,000 to invest in your RRSP and are in a 50% tax bracket, you would need to contribute $20,000. Your tax refund would be $10,000, so you are net out-of-pocket $10,000, which was the cash you have available.
How could you do this? You could contribute $10,000 plus take a short RRSP loan for $10,000 (or use a line of credit). Use the tax refund to pay off the loan.
If you are contributing monthly and have reduced your tax at source (or are contributing to a group RRSP), then you are essentially doing the gross-up.
Let’s look at how these 3 options affect the TFSA vs. RRSP battle. Here, the point is most clearly shown when we ignore investment return (assume 0%) and look at only one contribution. For simplicity, we assumed a 50% tax bracket before and after retirement.
If you have $1,000 of available cash, here are your options:
TFSA vs RRSP
| With 0% Return | With 10% Return | ||||||||
| RRSP only. | RRSP w. | RRSP w. | RRSP w. | RRSP w. | |||||
| Year | Spend Refund | Refund | Gross-up | TFSA | RRSP | Refund | Gross-up | TFSA | |
| 0 | $1,000 | $1,000 | $2,000 | $1,000 | $1,000 | $1,000 | $2,000 | $1,000 | |
| 1 | $500 | $1,100 | $1,600 | $2,200 | $1,100 | ||||
| 2 | $250 | $1,210 | $2,010 | $2,420 | $1,210 | ||||
| 3 | $125 | $1,331 | $2,336 | $2,662 | $1,331 | ||||
| 4 | $63 | $1,464 | $2,632 | $2,928 | $1,464 | ||||
| 5 | $31 | $1,611 | $2,927 | $3,221 | $1,611 | ||||
| 6 | $16 | $1,772 | $3,235 | $3,543 | $1,772 | ||||
| 7 | $8 | $1,949 | $3,566 | $3,897 | $1,949 | ||||
| 8 | $4 | $2,144 | $3,927 | $4,287 | $2,144 | ||||
| 9 | $2 | $2,358 | $4,321 | $4,716 | $2,358 | ||||
| 10 | $1 | $2,594 | $4,754 | $5,187 | $2,594 | ||||
| Before Tax | $1,000 | $1,999 | $2,000 | $1,000 | |||||
| After Tax | $500 | $1,000 | $1,000 | $1,000 | $1,297 | $2,377 | $2,594 | $2,594 |
Key Factor 2 Winner
TFSA. Only if you consistently gross-up all of your RRSP contributions, does the RRSP match the TFSA. Few Canadians do this. If you spend the tax refund, you would be far ahead with a TFSA. Even if you regularly contribute your tax refund, the TFSA wins, but not by a wide margin.
Note that if you always contribute the refunds, you end up contributing the same amount over time, but you are always behind the TFSA because you invested later. However, with a 10% return, you are only about 10% behind the TFSA at retirement.
Overall Winner: TFSA vs. RRSP
Overall, the TFSA will win for about 80% of Canadians.
- If you will spend your tax refund, then the TFSA clearly wins in almost any scenario. Note this is what most people do.
- If you regularly reinvest the tax refund or gross it up, then you should go back to the stage 1 rules of thumb. The TFSA also wins in most categories in stage 1. However, RRSP’s do win in one large category that would include 1/3 to 1/2 of Canadians – those with a reasonable working income and modest retirement savings or pension.
- If you would be tempted to withdraw from a TFSA, since it will be so much easier than withdrawing from an RRSP, then the RRSP may be better for you.
- TFSA limits are only $5,000/year, which is too little for most Canadians to maintain their existing lifestyles after they retire. RRSP’s allow much more contribution room, unless your income is under $30,000.
Final Thoughts
After declaring TFSA the winner for about 80% of Canadians, the best advice, however, will be to use a combination of TFSA and RRSP.
The purpose is to end up with a taxable income in retirement between $15,000 (or $20,000) and $31,000. If you can, then you will be in a low bracket in retirement. Note these brackets will likely be increased for inflation every year, so the brackets may be about double in 25 years.
You can achieve this by having a “modest” RRSP and the rest of your savings in a TFSA. Therefore, you should aim for your RRSP to be no more than about $350,000 now, which would be about $750,000 in 20-25 years.
We find that when our retired clients have a significant RRSP or pension plus a significant nest egg that is non-RRSP, then we can plan their retirement income very effectively. We can decide how much to withdraw from each source each year. Large non-RRSP portfolios are not that common for Canadians, however.
Now that we will have TFSA’s, the goal will be to build up a good nest egg in both a TFSA and an RRSP. This will provide all kinds of planning opportunities to minimize tax after you retire.
All these planning opportunities provided by TFSA’s are the dream for financial advisors. This is why we consider the TFSA to be the best improvement in retirement income planning for at least 50 years.
Photo credit: Anlex Basilio
17 Comments, Comment or Ping
1. Al
My choice is to put money in the RRSP and put the tax return in the TFSA. Save Save Save!
Apr 10th, 2008 @ 11:11 am
2. JR
contrary to my general line of thinking, but only for this thread, I would
In year 1, Contribute 50% of the available RRSP you have for this tax year, say $5k (the earlier the better)
When the tax return comes in (say $2k, plonk that along with a personal top up (in the amount you contributed the previous year $5k) this then gives you in year 2a $7k contribution, that now returns $2.8k.
Take the $2.8k return in year 2, add to that the $5k, now you have $7.8k, and a tax return of $3.12k in year 3. For year 4 you now have a contribution of $5k + $3.12k = $8.12k, for a tax refund in yr 4 of $3.248. At year 5, from your own money again $5k + $3.248k = $8.248k, would give you a tax return of $3.296
compounding is wonderful, in a few short years CRA will have matched your original $5k RRSP contribution, well fairly close to it.
Numbers and amounts contributed can vary, as with the ROR in the RRSP account as well as your personal tax rate. I used a simple example.
Once the pot is full to a level that you can do things with the RRSP account, that is the time to melt down and do the smart exchange RRSP for other tax savings methods
Apr 10th, 2008 @ 12:50 pm
3. George
“RRSP’s allow much more contribution room, unless your income is under $30,000.”
This is only true for employees that don’t have pension plans, since a “pension adjustment” occurs on your RRSP contribution limit each year, which can reduce the available room substantially.
My income is above $30,000, but I’ve got a very good pension plan. My RRSP limit for 2008 is only $1900. As a result, I’ll have far more room available in the TFSA.
Starting in 2009, I don’t anticipate putting a penny into my RRSP unless my TFSA has been fully “maxed out” for the year.
Apr 10th, 2008 @ 3:25 pm
4. Daniel
With retirement a few decades away for me, it seems hard to find the right trajectory to end up with the optimal amount in RRSPs. If I max out TFSA first, I can always move funds from TFSA into RRSP later when the path will (hopefully) be clearer. I will probably be in a higher tax bracket later too, so I will get more benefit from RRSP contribs later as compared to now.
Is this approach sound?
Apr 10th, 2008 @ 3:46 pm
5. JR
Daniel, only you can decide whether to go the TFSA first and RRSP second.
RRSP’s give you tax free money to put into an RRSP.
Both the RRSP & TFSA can get you bonuses when invested properly.
If you dont use the RRSP contribution today, the amount available will just keep increasing, and at some point you may wish to take the TFSA funds and make that contribution
At some point should you have built a nice tidy RRSP nest egg, you would have enough RRSP (half way down the road to retirement)to start the meltdown.
My rule is, to always pay yourself first, and if you can do that with OPM, all the better
Apr 10th, 2008 @ 4:08 pm
6. JCR
“The purpose is to end up with a taxable income in retirement between $15,000 (or $20,000) and $31,000.”
Ed, is this taxable family income or personal income (e.g., a couple could have up to $62,000 if split equally)? And does this include dividend income and capital gains, or only income taxed at the full marginal rate?
Apr 10th, 2008 @ 8:06 pm
7. JR
Ed,
Using the calculator/tables provided by service Canada its easy to see how much GIS or allowance a person or couples will qualify for.
http://www1.servicecanada.gc.ca/en/isp/oas/tabrates/tabmain.shtml
This is not for everyone, but if you really want to milk this, then planning is required to make sure that income at 65 is minimal.
One thought for those planning to go all the way to 65 was to start collecting CPP at 60 at the reduced rate, along with the not deducted CPP premiums, banking it or putting it into an RRSP or tax deferred vehicle, then hopefully topping up OAS & CPP with supplements at 65.
Apr 10th, 2008 @ 8:39 pm
8. George
JCR: It’s extremely difficult to factor dividends and capital gains into the equation, since the tax rates on these forms of income are likely to change between now and a future retirement date. My guess is that Ed’s numbers are based on regular taxable income for individuals.
No matter what I do, I’m going to have a retirement income that’s greater than $31k (because I’ll have a pension that pays me more than that) so I’ll be doing what I can to minimize taxable income in retirement - I’ll use TFSAs instead of RRSPs as soon as they become an option.
Apr 10th, 2008 @ 9:20 pm
9. Daniel
Would the interest incurred on a loan for investing in a TFSA be tax deductible?
Apr 11th, 2008 @ 11:00 am
10. Sarlock
It seems to me the placement of investments in to a combination of RRSP, TFSA and non-registered portfolios allows you the opportunity to carefully place different parts of your diversified portfolio in to different locations with regard to tax implications.
The riskiest part of your portfolio, which usually garners capital gains/losses, is probably best placed outside of your RRSP/TFSA. This way you can carry forward losses and enjoy a fairly nice tax rate on the gains. If you make capital gains in your RRSP, you are charged at your marginal tax rate at retirement, which may prove to be higher than the tax rate you would pay today on a capital gain.
The safest part of your diversified portfolio, the interest income earners, your bonds, money market funds, etc, are located in your TFSA. This is because the tax rate for interest is highest of the three types of returns. This gives your overall portfolio more stability during market turmoil (like right now) and provides you with tax free interest income.
The rest of your portfolio, a mix of medium risk growth stocks, dividend earners, resources, etc, goes in to your RRSP. Again, this will depend on your expectations of tax rates upon retirement. It may indeed prove to be more tax effective to invest in dividends outside of your RRSP if you expect a fairly high tax rate upon retirement.
In this way, you may be able to pay more tax now, at a favorable rate (via dividend tax credits, capital gains tax rates) and reduce your income at retirement, thus potentially qualifying for part of the GIS.
I will likely plan my retirement strategy to exhaust the majority of my RRSPs first (between 50 and 60) and leave the TFSA to compound as long as possible before withdrawing from it. This way, I can live nearly tax free in my later retirement years.
Daniel: You won’t be earning any taxable income from your TFSA, so I doubt you’ll be able to claim your interest to invest in it.
Apr 11th, 2008 @ 1:25 pm
11. johnnycanuk
TFSA’s are new. The government has not outlined all the rules to apply to them yet. Do not expect any tax relief when investing in them. Only the interest earned will be free of taxation. No one knows if mutual funds and shares can be held within a TFSA. The maximum to date is $5000 per year. Expect these TFSA’s to be secured investments paying a low interest rate. Always remember that the rules can be changed on a whim of the elected politicians. If they become highly used, expect some form of taxation to be applied.
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.
Apr 12th, 2008 @ 12:35 am
12. George
Johnnycanuk: According to the CRA, a TFSA should be able to hold pretty much any investment that can be held in an RRSP (see http://www.cra-arc.gc.ca/agency/budget/2008/taxfree-e.html#q9 ) for details.
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.
Apr 12th, 2008 @ 1:36 am
13. Ed Rempel
Hi JCR,
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
Apr 15th, 2008 @ 12:47 am
14. Ed Rempel
Hi Daniel, Johnny and George,
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
Apr 15th, 2008 @ 12:48 am
15. Gates VP
OK, so I’ve recently moved to the US and I’m behind the curve here on Canadian content.
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?
Apr 17th, 2008 @ 1:38 am
16. FrugalTrader
Gates, I don’t know a lot about ROTH IRA’s/IRA’s, but from my understanding, yes they are similar. The biggest difference being that IRA’s have a penalty upon withdrawal where TFSA’S do not.
Apr 17th, 2008 @ 5:09 am
17. Chuck
Gates: the TSFAs are like Roths. The difference is a Roth is still a retirement savings account. The TSFA is a savings account you can pull money out to do anything: buy a house, car, vacation, or fund your retirement.
The government said that the TSFA was based on a UK program.
Apr 17th, 2008 @ 6:07 pm
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