RRSPs and TFSAs: The Building Blocks of a Retirement Plan
Once upon a time life was simple. When I started my career in the financial planning business in 1991, RRSPs were the vehicle of choice for saving for retirement. It was almost a no-brainer that if you had taxable income you should be contributing to your RRSP.
Then in 2009 along came the Tax Free Savings Account (TFSA) that offered another vehicle for tax-sheltered savings. To complicate matters further, with the gradual reduction in corporate tax rates and the introduction of new investment vehicles in recent years, when it comes to retirement savings options for business owners, the wisdom of contributing to an RRSP versus saving in a holding company has come under question.
As with any financial planning question many factors need to be considered when looking for the correct answer. So let’s look at the pros and cons of using RRSPs and TFSAs as a savings tool for retirement.
When you contribute to your RRSP, you can deduct the amount from your income and save taxes and your savings inside the RRSP will grow tax-sheltered. The tax deferral will result in a bigger nest egg for you down the road, compared to saving the same amount of money in a non-registered account and being taxed on the growth each year. To reduce your 2011 income you can contribute 18 per cent of your 2010 income minus your pension adjustment (if you are a member of a registered pension plan) to a maximum of $22,450 to your RRSP before Feb. 29, 2012.
You can keep contributing to your RRSP up to age 71, at which point you have to convert it to a life annuity or Registered Retirement Income Fund (RRIF) and start withdrawing a minimum amount each year which will be taxable as income. So down the road you will have to pay taxes when you use your RRSP savings for generating retirement income (or in case you need to withdraw money from your RRSP before retirement).
The best case scenario for RRSPs would be if you are in the highest tax bracket during your saving years and the lowest tax bracket during your retirement.
Currently in Ontario the highest marginal tax bracket (the rate at which every dollar that you earn over and above $132,406 is taxed) is 46.4 per cent and the lowest marginal tax rate is 20.05 per cent (applicable to income up to $39,020). The worst case scenario would be if the reverse is true. Although this may be rare, it can happen as a result of success in business in later stages of life, a significant inheritance, or lottery winnings.
Due to the fact that withdrawals from an RRSP or RRIF are taxable as income, they will also negatively affect certain government benefits such as Old Age Security and Guaranteed Income Supplement that are income based.
Using the TFSA as a Retirement Saving Vehicle
TFSAs are basically the mirror image of RRSPs. Starting in 2009, each year you can contribute a maximum of $5,000 after tax income to your TFSA. Your savings will grow on a tax exempt basis inside the TFSA and you can withdraw money from your TFSA on a tax free basis as well. You can carry forward your TFSA contributions. So if you have not started contributing to your TFSA yet, in 2012 you can contribute $20,000 to our TFSA ($5,000 for each year since 2009).
TFSAs are more flexible than RRSPs in the sense that you can withdraw money and contribute it back to your TFSA the following year. However, if you withdraw money from your RRSP, you will lose that contribution room forever, and can only contribute to your RRSP based on new contribution room that will be created for you in future years. If you have not contributed the maximum allowable amount to your RRSP in previous years, the unused room dating back to 1991 will be added to your allowable contribution limit.
While TFSAs can be used as a short term savings vehicle and a parking spot for emergency funds, given today’s low interest rate environment and the meagre rates of return on high interest savings and short term GICs, you can take the most advantage of the tax free growth of your savings inside the TFSA and the eventual tax free withdrawals if you use the TFSA for long term savings and shelter the more substantial gain that you expect to have down the road from capital gains resulting from the growth of your stocks or equity mutual funds.
RRSPs vs. TFSAs
Over a 20-year period, assuming that at retirement you are going to be in the same tax bracket as today, the results are going to be the same whether you contribute $1,000 each year to your RRSP or $600 ($1,000 after 40 per cent tax assuming a 40 per cent tax bracket) to your TFSA.
If you end up being in a higher tax bracket at retirement than you are today, then the TFSA will help you end up with a higher after tax income at retirement. Conversely, if you end up in a lower tax bracket at retirement than during your saving years, then assuming all else is equal, the RRSP will yield better results for you.
It is also interesting to note that if you contribute $1,000 after tax to your TFSA each year and $1,000 to your RRSP each year, you will end up with substantially more savings in the TFSA because you have effectively saved more money in the TFSA. To net $1,000 if you are in a 40 per cent tax bracket you need to make $1,666.66 before tax. If you were to save $1,666.66 in your RRSP each year and $1000 in your TFSA each year, which means that if you were to reinvest the tax refund that you get as a result of your RRSP contribution back into your RRSP each year, then the net results would be the same over a 20-year period.
Therefore, the key to success with using the TFSA or RRSP strategy is consistency of savings and having the discipline to save the tax savings resulting from RRSP contributions or setting aside the equivalent after tax amount to save in a TFSA each year.
Similarly, the fact that you can withdraw any amount you want from your TFSA without any tax consequences may be a temptation to some people who may withdraw money with the best intentions of contributing it back but never actually get around to doing that. The fact that RRSP withdrawals are taxable and you will have to pay tax on them based on your highest marginal tax bracket is a sobering thought for most people who may contemplate tapping into their retirement savings for emergencies.
Finally, TFSAs allow you more flexibility when it comes to income splitting than RRSPs do. Income splitting is a strategy that allows you to split income with your family members to reduce your overall taxes by ending up in a lower tax bracket.
You can use this strategy with RRSPs by establishing a Spousal RRSP, where contributions would reduce the income of the higher earning spouse (the contributor) but will be saved in the RRSP of the lower income earning spouse. Withdrawals from a Spousal RRSP will be attributed for tax purposes to the contributing spouse in the year of contribution and the three subsequent years. After that they will be taxed in the hands of the lower income spouse in whose name the Spousal RRSP has been established.
From time to time the Income Tax Act’s attribution rules forbid income splitting between spouses. Interestingly, this does not apply to Tax Free Savings Accounts (TFSA). Unlike a regular savings or investment account, the income earned in a TFSA account does not have to be attributed back to the contributing spouse. This makes the TFSA a great tool for income splitting.
If you earn more than your spouse and are in a higher tax bracket, you can contribute $5,000 to a TFSA set up for your spouse who is in a lower tax bracket and this way the investment income can be taxed in the hands of the spouse who is in the lower tax bracket resulting in substantial tax savings over time.
Unlike RRSPs, where your contribution room is based on your earned income in the previous year, you can save money in a TFSA even if you have no earned income. Therefore, a couple can contribute up to $10,000 a year to TFSAs and enjoy tax free growth of their investments and savings even if one of them does not work and has no earned income.
The final Verdict
In an ideal world you should save the maximum allowable amount each year in both your RRSP and TFSA to take advantage of all the tax savings that each vehicle offers. Unfortunately we do not live in an ideal world. Therefore, the right answer depends on your personal circumstances and you should consult a qualified financial advisor to determine what the right strategy would be in your case. However, no matter which vehicle makes the most sense for you, if you consistently update your financial plan and roadmap for retirement, diligently save and resist the temptation to dip into your RRSP or TFSA savings you will have a very good chance of succeeding in realizing your retirement goals.
Tina Tehranchian, MA, CFP, CLU, CHFC, is a senior financial planner and branch manager at Assante Capital Management Ltd. (member of the Canadian Investor Protection Fund and IIROC in Richmond Hill, Ontario and can be reached at (905) 707-5220 or through her website at www.tinatehranchian.com. Please contact a professional advisor to discuss your particular circumstances prior to acting on the information above.