Money & Career
Retirement savings: TFSAs, RRSPs, or both?
Money & Career
Retirement savings: TFSAs, RRSPs, or both?
But which should you use first, and under which circumstances?
It's about taxes
The answer depends initially on the tax rates that will apply when you put money in and when you take it out. Both RRSPs and TFSAs allow your money to compound untaxed while in the plan.
With an RRSP, you get a tax refund for your contributions but pay full tax on withdrawals, whereas with a TFSA you get no tax break on contributions but pay no tax down the road.
"The most important factor to consider in choosing between RRSPs and TFSAs is what your tax rate will be in your retirement as opposed to your pre-retirement years," says Dave Ablett, director of tax and retirement planning at Investors Group Inc. in Winnipeg.
Determine your tax rate before you retire
"Generally, if your tax rate is higher in your pre-retirement years than during retirement, then you should try to maximize your RRSP first." Ablett adds, however, that most people don't have access to a generous pension plan, so RRSP contributions alone may not be adequate to fund a satisfactory retirement.
"First you should maximize the RRSP, but then you should take the tax refund from your RRSP contribution and invest that in the TFSA," he says. "People who do not have pensions should take maximum advantage of both plans, because you'll need to save quite a bit to meet your retirement expectations.
"On the other hand, if your income is going to be higher in retirement than in pre-retirement, then you should use only the TFSA," Ablett continues.
The rationale here is that if your income is going to rise when you enter retirement you could end up paying more tax on your RRSP withdrawals than you saved on the contributions.
In a case in which tax payable will exceed tax saved, you'd be better off to forego RRSPs altogether and put your savings into an ordinary non-registered investment account. That way you may also benefit from the preferential tax treatment accorded to dividends and capital gains.
The TFSA, however, allows you to turn taxable growth into completely tax-free growth on some of those investments each year, without fear of a tax bite down the road.
Page 1 of 4 – Learn more about the age and income considerations for RRSPs and TFSAs on page 2.
Such is the basic tax-related rule of thumb regarding contributions to RRSPs and TFSAs, but of course there often are other factors to consider in weighing the relative merits of these very different plans.
For many retirees, one of the beauties of TFSA withdrawals is that they will be "non-income" in all senses of the word, including their impact on government benefits geared to income.
Those whose incomes are low enough to qualify for the Guaranteed Income Supplement (GIS), for example, see their benefits reduced 50 cents with every dollar they withdraw from an RRSP. Similarly, those with high enough income (about $65,000 to $70,000, depending on the province or territory) may encounter the 15-per cent Old Age Security (OAS) clawback.
Taking age and income into consideration
The age credit on your tax return is also geared to income. In all these cases, TFSA withdrawals don't count as income and don't affect entitlements. The rules for TFSAs are relatively simple, and their versatility makes them attractive to a broad range of people, according to Wilmot George, director of tax and estate planning for Mackenzie Financial Securities Inc. in Toronto.
"The TFSA is a very flexible product, well-suited for many Canadians whether they're young adults just out of school, couples with kids, or they're retired.
"For example, anyone with a spouse in a lower income tax bracket, maybe a stay-at-home spouse, can split income by simply gifting the money to the spouse for their TFSA," George says.
"The lower-income spouse may even have no earned income to generate RRSP contribution room, but the TFSA still gives them access to tax-free savings." And, he adds, "TFSAs can be great for retirees older than age 71 because they can no longer own an RRSP and get a tax deferral on further savings. What they've invested is what they've got. But there are no age restrictions on TFSAs, so if a person is getting Registered Retirement Income Fund (RRIF) payments that he or she doesn't need, for example, those can be reinvested in a TFSA to avoid further tax."
TFSAs and estate planning
TFSAs can also have estate advantages, George notes, because RRSP/RRIF deregistrations in the year of death can translate into a big one-time tax hit on your final return (unless the plan proceeds can be rolled tax-free into the registered plan of a surviving spouse).
"Say John Smith has $200,000 in an RRSP or RRIF," George suggests. "Anything above $120,000 or so [depending on the province] is taxed at the top rate. In some provinces this can mean 50 per cent. If Mr. Smith is retired now and not earning a lot of other income, he could make extra RRSP or RRIF withdrawals to take advantage of the lower tax rate, then reinvest the money in a TFSA. From there on it would all be tax-free."
Page 2 of 4 – Discover some of the downsides to using a TFSA for short-term savings on page 3.
Because there's no tax hit on TFSA withdrawals, your money is much more accessible than in an RRSP – although this may be good or bad. On the plus side, accessibility makes the TFSA an attractive short-term savings vehicle: why put money in an ordinary bank account when you can put it into a TFSA, get tax-free compounding, then get it out just as easily?
You don't even affect your future TFSA savings potential because all withdrawals are added back into your contribution room the following year. "[A TFSA] is a great way to save for the short or long term since you are not taxed on the investment earnings and can withdraw your money at any time (subject to any investment restrictions)," according to RBC Royal Bank's website.
"This makes a TFSA a great option for saving and achieving your future goals: a dream vacation, a car, home renovations, or saving for emergencies and unforeseen events." But the flip side is that accessibility increases temptation. The tax hit on RRSP withdrawals introduces an element of "the stick," making that vehicle more of an enforced savings plan than the easygoing TFSA.
The downside to using a TFSA for short-term investments
In addition, Shawn Purcell, a senior financial planner with Assante Capital Management in Vancouver, suggests that using these plans for short-term needs may result in longer-term loss.
"A young couple may have a $200,000 mortgage and they're probably paying prime, say a five-year mortgage at four or five per cent," Purcell says. "It doesn't make sense for them to have a TFSA paying them one per cent at the same time. They're not earning anything – they're just paying for the spread."
In this case, the mortgage should be the top priority because you would need to earn as much as 10 per cent guaranteed before tax to cover that five-per cent mortgage plus tax at the top marginal rate. Purcell adds that meeting short-term cash needs with a TFSA usually means investing in low-paying short-term GICs or money market mutual funds, so the growth on which you're saving tax is actually minimal.
"You're better off using the TFSA for longer-term investments to maximize the benefits of that tax-free compounding," he says. "There's something to be said for putting riskier assets into TFSAs because they have the highest growth potential, although this type of decision always depends on your risk tolerance and your investment objectives."
Page 3 of 4 – Should you consider RRSPs and TFSAs? Find out on page 4.
Potential savings with TSFAs still small
While TFSAs are attractive in many situations, the total dollar value of tax relief that can be gained from them is still relatively limited.
Introduced in 2009, the $5,000 annual maximum means you've probably accumulated (or used) $10,000 in total room so far. That's not enough to make much of a dent in a $200,000 RRSP tax bill, although certainly every bit helps, especially for those of modest means. And the contribution limit is cumulative as well as indexed, so it will grow over time.
The benefits of RRSPs
Nevertheless, despite the TFSA's attractions, RRSPs will remain the primary tax shelter for most retirees, at least in the foreseeable future. The TFSA limit is still relatively small and as mentioned earlier, those whose income will be falling in retirement – and that means most of us – will benefit tax-wise from RRSPs.
In addition, RRSPs can be rolled into RRIFs (or annuities) from which withdrawals/ payments after age 65 can be eligible for the $2,000 pension income credit.
Couples can split this pension income to double the amount of tax-free RRIF income they can receive. That still doesn't mean TFSAs shouldn't be considered as well, especially by those receiving income-geared government benefits such as GIS (this is one group that could certainly benefit much more from a TFSA than an RRSP).
Should you have both RRSPs and TFSAs?
But most people will continue to rely more on RRSPs to achieve their retirement savings goals. "If you're now earning a high income and want to put some money away and don't expect a high income in retirement, then use the RRSP," George says. "But in general we always encourage people to look at them as complementing one another, not competing. We think both plans should be used together."
Ablett concurs, adding everyone should have a TFSA even if you also have an RRSP.
"Anything that helps you build up tax-free savings is a good thing," he says. "The beauty of TFSAs is if you do need to make a sudden withdrawal for say, medical reasons, you're not hit with a big tax bill. Or if you're moving into assisted care, withdrawals won't affect your benefits. Or if you have both non-registered and registered assets, you can move the non-registered ones into a TFSA, and turn a taxable into a non-taxable income source. That's why we suggest people at least put the tax refund [from their annual RRSP contributions] into a TFSA."
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