The retirement savings dilemma: RRSP or TFSA?
The Tax-Free Savings Account is now a little more than three years old but most investors still aren't taking advantage of its potential.
While two thirds of Canadians feel they're knowledgeable about both RRSPs and TFSAs, 40 per cent admit they still don't understand the difference between the two, according to recent research from BMO Financial Group.
That's odd, because other than the amount of money you can put in, they're pretty much mirror images of each other.
The big difference between an RRSP and a TFSA is the timing of the taxes you'll eventually pay. Remember: the two plans are designed to produce the same results, assuming you're going to end up with the same tax rate down the road.
But, for many people, that's not going to be the case.
If your marginal tax rate is higher at the time of contribution, an RRSP will be the better choice since it will defer tax to a point in the future when your income, and consequently your marginal tax rate, will be lower.
This is the most likely scenario for most Canadians since those who are currently retired manage, on average, on about 50 to 60 per cent of what they made when they were working.
If the reverse is true and your income actually goes up in retirement, however, a TFSA would make more sense since you'll be able to spend 100 per cent of those eventual withdrawals.
Which is better? Well, it depends. And the farther you are from retirement, the more difficult it is to things figure out.
But it's still worth a try, particularly now that you can put in up to $20,000 ($40,000 for couples) in a TFSA — providing you've never had one before.
What's more, the Conservative government has pledged to double the annual contribution limit from $5,000 to $10,000 once the federal budget is balanced.
Here are the important factors: RRSP contributions are made with pre-tax dollars, and while they generate tax deductions, withdrawals will be taxed as ordinary income. TFSA contributions, however, are made with after-tax dollars, and eventual withdrawals will be tax free.
In some instances, there may be an advantage to intentionally storing up RRSP room, and using a TFSA in the interim. Should your income jump, TFSA funds can be withdrawn to make an RRSP contribution, creating TFSA repayment room at the same time.
Remember, unlike money you take out of an RRSP, the amount you withdraw from a TFSA can find its way back into the account in a future year without impacting your contribution room.
This strategy might appeal to young professionals, for example, since their income generally jumps significantly after completing years of training.
Similarly, if you're a public service worker with a guaranteed pension, you're really limited as to how much you can put into RRSPs to begin with so the TFSA becomes a more viable option if you have cash on hand.
Small business owners who leave money in the business and draw only a moderate salary may want to consider the TFSA route as well, because any immediate RRSP deduction they get is likely to be fairly small.
If you're close to retirement, it may even be time to skip the RRSP altogether and start aggressively funding the TFSA.
Affluent older investors should factor in the clawback of retirement benefits like Old Age Security (OAS), which are unaffected by any income withdrawn from a TFSA.
This might be an even bigger issue if recent rumours about the government lowering the clawback threshold prove to be true.
This clawback threat, combined with the steadily increasing contribution room available within a TFSA, means some older investors may benefit from making annual withdrawals from their RRSP and depositing the proceeds to their TFSA before age 65.
This way, at 65, more assets would be held outside the RRSP and the withdrawals from the TFSA could take the edge off the annual tax bill, thus protecting their OAS benefits.
And, if you're really looking ahead, remember that, unlike an RRSP, which must be converted to a retirement income vehicle at age 71, a TFSA doesn't have any minimum withdrawal requirement.
Of course, all this is an exercise in assumptions. And, since it's a relatively young program, the TFSA rules could easily change down the road.
For instance, Armine Yalnizya, an economist with the Canadian Centre for Policy Alternatives, maintains that lifetime TFSA contributions should be limited to $50,000.
The tax-free growth of assets in the account should also be limited to $150,000, he argues. And that would certainly change the overall equation.
If you can, use both the RRSP and TFSA room to the maximum. If you don't have enough cash on hand to fully load up in each, at least have someone calculate the relative merits of each.
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