TFSA versus RRSP — Do the Math!
2010 is the start of the second year that Canadian residents who are 18 years of age or over can make their annual $5,000 contribution to a tax-free savings account (TFSA). The deadline for 2009 registered retirement savings plan (RRSP) contributions is also fast approaching.
Although there are similarities and differences between a TFSA and a RRSP, anyone who has sufficient funds will generally find that it is advantageous to contribute the maximum to both registered plans. Also, in the situation where one spouse earns all of the family income, that spouse should consider providing the funds to contribute to a TFSA for the non-working spouse. Unlike most other transfers of funds for the benefit of a spouse, the attribution rules will not apply to require the working spouse to report any income or gains from the TFSA.
However, what about the situation where an individual does not have sufficient funds to maximize contributions to both plans?
Theoretically, assuming an individual’s situation does not change over time — i.e., the marginal tax rate stays the same and the rate of return earned within either plan remains the same — both plans should result in the same net proceeds at the end of the holding period. For example, when the TFSA was first introduced, the Department of Finance created a table comparing the two types of plans assuming an initial starting point of $1,000 pre-tax income, a 20-year holding period, a constant 40% marginal tax rate and an assumed 5.5% yearly rate of return. After 20 years, the net proceeds for both plans were the same ($1,751). The RRSP is initially favoured, due to the tax deduction and the ability to generate more investment income. However, the amounts balance out at the end due to the fact that the RRSP is eventually taxed on withdrawal, but the TFSA is not.
Needless to say, the above fact situation is far from realistic. As a result, each individual situation has to be assessed to determine the optimal planning strategy. In many cases, the marginal rate of tax on withdrawal from an RRSP should be less than the rate in effect when the amount was contributed to the plan. In this situation, where funds are limited, the RRSP would be the better choice. However, if the individual expects that his or her marginal rate of tax will be higher on withdrawal, then the TFSA would be preferred. For example, students and low income earners who historically may have contributed small amounts to an RRSP should consider switching to a TFSA.
Another significant benefit of a TFSA is the ability to use that account to manage the level of retirement income. Since RRSP withdrawals are taxed as ordinary income, they may reduce the holder’s net income-tested benefits, such as Old Age Security (OAS), the Guaranteed Income Supplement (GIS) and the age credit. Whether or not these benefits will be reduced will depend on the holder’s anticipated net income in retirement. The GIS is only available to very low income seniors. For 2010, the federal age credit will begin to be reduced once an individual’s net income reaches $32,506 and the OAS will begin to be clawed-back at a net income level of about $66,700. For anyone whose net income will be near one of these thresholds, the well planned use of a TFSA can result in additional tax savings. For example, consider a 70-year old single woman living in Ontario who requires approximately $36,000 annually after tax to meet her expenditure needs. Assume her combined OAS and CPP income is $15,000, with the balance to be received from a RRSP. The required RRSP withdrawal will be about $27,500. Conversely, that same person could receive $17,000 from her RRSP and $7,500 from a TFSA. In both cases, she will have the same amount of after-tax income. However, in the first situation, her age amount is ground down by more than $1,500 (whereas it is fully available in the second situation).
A question that has often arisen in the past is whether a person should pay down non-deductible debt (such as a mortgage) or contribute to a RRSP. This old debate has gained a new layer of complexity with the addition of the TFSA. In many respects, most of the same considerations come into play — the mortgage rate, the expected rate of return on the RRSP/TFSA investment and the marginal tax rate of the holder on withdrawal from the RRSP. Where a contribution to a TFSA might make sense (based on the discussion above), individuals with limited funds now have to decide whether or not to pay down their mortgage or contribute to a TFSA. Since TFSA contributions are in after tax dollars, the decision will generally be based on a comparison of current and future mortgage rates with the expected investment return in the TFSA.
For many individuals, the optimal choice will be to use both RRSPs and TFSAs to provide maximum investment and planning flexibility. However, in the situation where a taxpayer has to choose between the two types of registered plans, there are certain situations where an RRSP is not the only retirement option that makes sense. Low income individuals and individuals nearing retirement who can use TFSA withdrawals to manage their level of retirement income should give serious consideration to a TFSA. The important thing to remember is that the TFSA is another weapon in a taxpayer’s arsenal. Depending on an individual’s particular circumstances, it can be used alone or in concert with other savings and investment vehicles to maximize after-tax income.