TFSA or RRSP? February 2013

Lately, one question clients are asking me is whether they should contribute to a Tax Free Savings Account (TFSA) or a Registered Retirement Savings Plan (RRSP)?  Personally, I really like the TFSA. however it doesn’t have to be an either or choice.  Why not do both?  If both, in what proportion should you divide your contributions?  In order to make an informed decision, let’s quickly review the main features of each program as discussed in last month’s article.  I will use bullets to illustrate the features as nothing gets people’s attention more than bullets.

TAX FREE SAVINGS ACCOUNT

•  Any Canadian resident age 18 or over may open a TFSA. Contribution is not based on earned income.  There is no maximum age for contribution.
• Maximum contribution is $5,000 for each year from 2009 to 2012 and must be made by December 31^st of the year of contribution.  For 2013, due to indexing the maximum contribution is $5,500.
• There is carry forward room for each year in which the maximum contribution was not made.
• The deposit is not tax deductible, but the funds accumulate with no income tax payable on growth.
• Withdrawals may be made at any time on an income tax free basis.  Withdrawals create additional deposit room commencing in the year after withdrawal.

REGISTERED RETIREMENT SAVINGS PROGRAM

• No minimum age for contributing, but must have earned income sufficient to generate RRSP contribution room.
• Maximum contribution is 18% of earned income based on your previous year’s earnings to a maximum of $ 22,970. For 2013, the maximum will increase to $ 23,820 due to indexing.
• There are carry forward provisions for years not contributing.
• Contribution is tax deductible from earned income, and the funds accumulate on a tax deferred basis.
• All contributions are taxable at top marginal rate of income tax, based on earnings in year of withdrawal.
• RRSP ends in year contributor turns age 71, when the RRSP must be converted to a Registered Retirement Savings Plan or life annuity and taxable income taken.

Now that we have reviewed the provisions of each program, let’s try and analyze what program works best for us and in what proportion.

Both programs provide for no tax on the earnings on the contributions, no difference there. However, only the TFSA allows for withdrawals with no tax – EVER.  If you are not reinvesting the tax savings generated from your RRSP contribution, the only thing you gain is an increase in consumer spending created by the tax saved.  The truth is, however, that the tax deferred is really a loan from the government. Although, they don’t charge interest on this loan, the loan must be repaid at some point in the form of taxes on withdrawal.  And like most things in life, that point usually comes when you can least afford it, like when you quit working, or require funds for an emergency.

Be careful not to over value your RRSP balance.  It is important to remember that the balance will be reduced by the tax payable.  If you are certain that you will retire in a lower marginal tax bracket than you are now, then the RRSP makes some sense.

This is also true if you routinely reinvest the tax savings but otherwise, at the end of the day, there is no difference in the final results of the two programs.  This can be illustrated in the table below:

*marginal tax rate pre and post-retirement

Both programs lend themselves very well to each other.  If you refer to the features of each listed above, the RRSP’s have to be converted into income starting no later than the contributors age 71.  Assuming retirement at age 65 (yes, some people still do that), there are 6 years that bridge income will have to be provided, and what a better way than to have that income paid from a source that is completely free of tax (TFSA)?  At the same time, the requirement to pay tax on withdrawing from an RRSP helps to ensure that those funds will actually be saved for retirement.  RRSP’s were never designed to be a “rainy day fund”, but that purpose is well served by a TFSA.

 If you can contribute the maximum to both – GREAT! If not, you should still take advantage of both programs.  Try to establish a ratio of contribution that you are comfortable with and go with that. Remember, you can always change the ratio from one year to the next, and whatever plan you don’t maximize this year, your contribution room going forward will allow you to catch up later.

While the rules governing TFSA’s are relatively simple, this is not true with RRSP’s and is beyond the scope of this article. It is best to fully discuss the benefits and restrictions of each of these options before investing. Let’s talk and see what’s right for you.