The Rising Power of the TFSA: Are RRSPs even relevant anymore? (by Jonathan Chevreau)

Now that most Canadians and their advisers have gotten the message across about the rising power of tax-free savings accounts (TFSAs), some are beginning to question whether RRSPs are even relevant anymore.

However, there is no ‘one size fits all’ retirement plan.  Plans should vary depending on a number of factors including, your age, lifestyle, debts, etc.

The Sweetness of the RRSP

Remember first that the RRSP and TFSA are mirror images of each other.  Mathematically, they behave in almost the same way in terms of the ongoing elimination of tax on investment income, but where the RRSP has an upfront tax deduction that lets contributors lower their taxable income, the TFSA does not.

On the other hand, the sweetness of the RRSP’s immediate tax refund is ultimately negated by the sourness of retirees eventually being forced to withdraw money from RRSPs (or the RRIFs they become at age 71), withdrawals that are taxed, and which may also cause the clawback of such government benefits as Old Age Security and the Guaranteed Income Supplement.

Blinded by the Tax Refund

In their early years, some still working may have been — to use the phrase coined by CIBC Wealth’s Jamie Golombek – “blinded by the tax refund” created by RRSPs, and so favoured the RRSP over the TFSA, which provides no such immediate gratification.

But fast forward to the far future, when you’re retired and withdrawing money from various sources.  Let’s try a thought experiment and imagine you have $300,000, spread evenly between an RRSP, a TFSA and non-registered savings.

So if the RRSP ultimately is taxed so harshly relative to the two alternatives, then why invest in one at all?

TFSA vs RRSP: Which is Better?

The RRSP refund is really a red herring.  “You will end up paying this money back to the government, with interest (i.e. the growth on the “refund”), years later upon retirement and ultimate withdrawal,” Mr. Golombek says.  “The real question when deciding between an RRSP and TFSA, assuming you don’t have the funds to do both, is to compare your tax rate today versus your expected tax rate in retirement.”

Which of these pots of money is most valuable?  I’d argue $100,000 in an RRSP is least valuable because eventually you’re going to be taxed on it, at your marginal rate just like earned income or interest income.  If it turns out your precise tax liability is $30,000, then you could argue that $100,000 is really worth only $70,000, net of the tribute you’ll ultimately pay to Ottawa.

Next consider the second pot, $100,000 in non-registered money.  This $100,000 should be “worth” quite a bit more than the same $100,000 in an RRSP because there are no forced annual taxable withdrawals from it.  It’s not tax-free, however, because it will generate perhaps 2% or 3% a year in taxable dividend or interest income.  And if you take profits on individual stocks (or funds), you will have to pay further capital gains tax on it.  But odds are this pot of money is going to be worth a lot more than the $100,000 RRSP.

Finally, consider the $100,000 in the TFSA.  If it’s invested totally in Canadian stocks or equity ETFs and some Canadian fixed-income, this $100,000 is worth almost exactly the full $100,000.  (There may be a bit of tax leakage from foreign dividends.)  Unlike the RRSP, you don’t have to make taxable withdraws from it after age 71, and, if you’re in a modest middle-income tax bracket and qualify for OAS, it won’t trigger benefit clawbacks.  Plus, if you’re among the seniors who have the least financial resources, that $100,000 TFSA won’t jeopardize GIS benefits or other means-tested benefits.

RRSP’s Big Benefits = Personal Pension Plan

So if the RRSP ultimately is taxed so harshly relative to the two alternatives, then why invest in one at all?  Well, remember the two big benefits.  First is the ever-tempting upfront tax refund.  If you’re in the top tax bracket and paying 46% tax on your last dollar of earned income or interest income, then a $10,000 RRSP deduction immediately reduces your taxable income for the previous year by $10,000, making it “worth” roughly $4,600: the amount by which your tax bill will be reduced that year.  That’s worth a lot, especially if — as the financial industry usually claims — you expect one day to retire in a lower tax bracket.  Since advisers often suggest that in retirement you can live on between 50% and 70% of what you earned in your working years, then it makes sense to get a tax deduction on those 46% dollars and decades later be taxed at perhaps a 20% or 30% tax rate.

And second, remember the ongoing deferred sheltering of investment income of both the RRSP and the TFSA.  All those dividends, capital gains and interest can be reinvested with no tax consequences during all those years you’re still working and contributing.  At the end, even after it’s taxed in the RRSP scenario, the pot of money will be the equivalent of an employer pension plan.  Because that’s in effect what an RRSP is: a personal pension plan.

Who Should Invest in an RRSP?

So should everyone invest in an RRSP and should they do so at all stages of their work lives?  No.  Young people just starting their work lives may be in a lower tax bracket.  They may be better off first maxing out their TFSAs, assuming they’ve first eliminated high-interest credit-card debt.  If and when they get into a higher tax bracket after several years in the workforce, they can consider adding to RRSPs as well.  Remember that you can “catch up” on any unused contribution room if you have the funds to do so.  If you don’t, any financial institution will be glad to give credit-worthy individuals a “catch-up” RRSP loan at prime to do so.

Alternatively, you can contribute to your RRSP as you go, but only opt to claim the deduction once you’re reached the years when you’re in the top tax bracket.

Who Should Favour TFSAs over RRSPs?

The other group that should favour TFSAs over RRSPs are those with limited financial resources who are nearing the traditional retirement age.  In particular, if you think you’ll be able to collect the GIS as well as OAS, then you’re much better off saving what little money you can put aside in a TFSA and avoid using RRSPs altogether.

Middle-income people who have accumulated six-figure RRSPs may also want to get a financial planner to look at their situation after age 60.  If you think you’ll be subject to OAS clawbacks after age 65 or 67, there may be a case to be made to start “melting down” your RRSP once you’ve stopped earning a full-time taxable income, in order to minimize the taxation and benefit clawbacks of RRSP/RRIF withdrawals after you turn 70.

Ideally, you continue to contribute the maximum to your TFSA, even well after age 70: to 90 and beyond!  You may fund the TFSA through the net (after-tax) proceeds of RRSP/RRIF withdrawals and/or transfers in kind (also taxable) of your non-registered investments.

At some point in old age, this would result in minimal registered savings and non-registered savings but very large TFSAs.  Ultimately, you may end up qualifying for OAS again and possibly even GIS, all the while drawing non-taxable dividends and interest income from what has become a huge six-figure TFSA.

This article was orginally published in the Financial Post on February 17, 2015.

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