TFSA or RRSP? Cutting through the Confusion (as seen on Money.ca)

Here is my article from Money.ca…

When it comes to choosing between a Tax-Free Savings Account (TFSA) and a Registered Retirement Savings Plan (RRSP), there are plenty of details to keep you up at night. It’s important to look at the pros and cons of each plan, so you can develop a financial plan that’s right for you.

Your personal Financial Plan should include the income per year you will need after you retire to have the retirement lifestyle you want. Your Plan should also calculate the amount you will need to contribute to TFSA or RRSP per year to achieve this.

This will help you determine the difference between your current tax bracket and the tax bracket you will experience after you retire. It’s easy to assume your income will be less, so your tax bracket will be less, but that is not necessarily accurate. Many government income programs allow clawback provisions that put many seniors in shockingly high tax brackets!

Clawbacks are just like a tax and they can be an unexpected cost. If you look at the breakdown of the three most common clawbacks, you can see the difference between having a TFSA or an RRSP. Here’s how the three clawbacks break down:

1.      Low income (less than $20,000) – 50% clawback on GIS

2.      Middle income ($35,000-$85,000) – 15% clawback on the age credit

3.      High income ($75,000-$120,000) – 15% clawback on OAS

You can own the same investments in your TFSA as your RRSP. The main difference is that RRSP contributions and withdrawals have tax consequences, while TFSA contributions and withdrawals don’t.

Therefore, the answer to TFSA vs. RRSP is primarily based on your marginal tax bracket today compared to when you withdraw after you retire.

Rule of Thumb

RRSP is better if:

• You will be in a lower marginal tax bracket during retirement. Example: Today you’re making $100,000 and you will receive $35,000 during retirement, you can get a tax refund of 43% on your current deposits and pay only 20% tax on your retirement withdrawals, giving you a gain on the actual value of your RRSP of 23%.

TFSA is better if:

• You will be in a higher marginal tax bracket during retirement. Example: Today you’re making $40,000 and you will receive $20,000 during retirement, you can get a tax refund of 20% on your current deposits and pay out 70% when you make retirement withdrawals. This figure includes lost GIS from the clawback. This saves you a 50% loss on your entire RRSP.

You can choose either an RRSP or a TFSA if:

• You will be in the same marginal tax bracket during retirement.

Other Details to Consider

If you are still unsure if an RRSP or a TFSA is right for you, answer these two important questions:

1.      How will I use my tax refund?

• TFSA is best if you plan on spending your RRSP tax refunds. Example: if you deposit $10,000 to either a TFSA or an RRSP and then spend the refund, the TFSA will give you a higher retirement income. You need to reinvest your tax refund for RRSPs to provide you the same after-tax retirement income as TFSAs.

2.      Is the withdrawal flexibility from my TFSA a pro or a con?

• Flexibility is good, but if you are tempted to withdraw before retirement, RRSP might be a better choice.

Sound Financial Planning

It is advisable to plan on retiring with a taxable income in the low-to-mid level tax brackets. Since the cash that you live on can vary from your taxable income, it’s important to remember that TFSA withdrawals that are non-taxable. They can give you cash income that is not taxable income. Other tax deductions must be factored in to figure out the tax bracket you will be in.

Example: Basic government pensions are $20,000. OAS is $7,000 maximum, based on your number of years residing in Canada. CPP can range from $0 to $13,000, depending on how much you’ve deposited in the past. From here, calculate your income from your RRSP and TFSA and any other investments. You can generally withdraw 3-4% (depending on how you invest) of your RRSP or TFSA each year and have it last as long as you live.

This should help you determine which plan is right for you. You can plan to be in the right tax bracket. If you currently earn $80,000 and will retire with $50,000, you may be tempted to think TFSA is best since you will get a refund of 31% today but will pay 34% at withdrawal. However, with only $5,000 per year from non-taxed TFSA, your taxable amount is down to $45,000 which puts you in the 23% category, so RRSP is actually better. In this example, you need enough TFSA for the $5,000 per year but the rest should go into RRSP.

Important Note

Don’t forget to adjust for inflation! All of your retirement calculations need to factor in inflation. It will roughly double your cost of living in 20 or 25 years.

Forgetting to include inflation is the most common error many people and advisors make in estimating retirement income and how large of a nest egg you will need.

What about non-registered investments?

In some cases, non-registered investments may actually be better. Just maximizing TFSA and RRSP is not always the best answer. If your taxable income in retirement will be in a higher tax bracket than now, non-registered investments might be a smarter choice. If using your TFSA to the maximum will still leave you in higher tax brackets, non-registered investments will give you more cash at lower tax brackets than RRSP.

Example: Currently you make $80,000 and you plan to retire with $80,000, you get a 31% refund now but will have to pay as much as 44% when you withdraw because of the OAS clawback. Upon retirement, you can only get $45,000 at lower tax bracket rates than your current tax bracket.

If you plan on getting $20,000 from government pension, then you need to plan now for enough RRSP to give you $25,000 income. The rest should be in TFSAs. However, that won’t be enough. You will still need $35,000 more. That’s when non-registered investments might pan out better for you than RRSPs.

But don’t forget the taxes. Non-registered investments are not always tax free, depending on how they are invested, and the interest is always taxable. Capital gains, however, are only half taxable. Dividends are given preferred tax rates but they also get higher clawbacks because the income for determining clawbacks is the “grossed-up dividend”, which is 38% more than the dividend.

Let’s look at a worst-case scenario for non-registered investments: a senior making $20,000 gets a dividend of $1,000 which has a clawback of $690 (50% of $1,380). In this case, there is no income tax, but you still lose $690 out of the $1,000 in reduced GIS income.

If you sell a bit of your non-registered investments each month, you can get a nice, low tax rate on the cash. My term for this is “self-made dividends.” Since your cash income is made up of your capital gains and your original investment, the tax is very low, often only 10% of your withdrawal.

Bottom Line

1.      RRSP –

• medium working income $50-80,000 and modest retirement savings
• high working income over $90,000

2.      TFSA –

• low working income under $45,000
• medium to high working income with no retirement savings
• medium to high working income with large retirement portfolio

How much should I save?

Generally speaking, a modest savings would be $500,000-$700,000 when you retire. Factoring in inflation, this would amount to approximately $1 million to $1.4 million if you plan to retire in two decades.

Plan in Place

Now is the time to prepare a Financial Plan that will help you sift through the options while understanding all the details such as tax brackets, clawbacks and inflation. In my experience, when my retired clients have a portfolio consisting of a good RRSP or pension, a strong TFSA and some non-registered investments, we can come up with a good plan for how much they can withdraw annually while minimizing the amount of taxes that are required.

With a mix of fully-taxed, low taxed and non-taxed sources of income, we can plan effectively for you to receive the cash for the retirement you want, while remaining in lower tax brackets.

A sound financial plan that cuts through the confusion of TFSAs and RRSPs set you up for a comfortable and worry-free retirement. It will have the optimal strategies that are right for you.

Ed