TFSA vs. RRSP – Best Retirement Vehicle?

“You give 100 percent in the first half of the game, and if that isn’t enough, in the second half you give what’s left.” – Yogi Berra

Tax Free Savings Accounts (TFSA’s) will be available in 2009. Should we be using them instead of RRSP’s to save for retirement?

The short answer is that there is not a definite answer. It will depend on your circumstances.

Since the real difference between them is the tax consequences, the answer depends on 2 key factors:

1. Marginal tax rates when contributing vs. marginal tax rates when withdrawing.
2. Use of the tax refund.

Stage 1

Most people assume that they will be in a lower tax bracket when they retire, since they will be making less income than while they are working. If this is true, that would be better for RRSP’s. In the introductory article about clawbacks on seniors, however, we saw that this is often not true.

The 3 main clawbacks on seniors are on the GIS, age credit and OAS. All of them apply to all seniors within that income bracket, so they will cost seniors real money.

The top tax bracket for non-seniors in Ontario is 46% which starts with a taxable income of $120,000. For seniors, however, when we include the clawbacks, we found that they are at a marginal tax bracket of 46% or higher if their income is either under $15,000 or over $37,000.

This $15,000 threshold below which the GIS 50% clawback applies will vary between $15-20,000. Use $20,000 if your income will include the maximum OAS (40 years in Canada at age 65) and you are single, and $15,000 if you are new to Canada or married.

This means that the only people that would be at a lower tax bracket after they retire will be those with a retirement taxable income between $15,000 (or $20,000) and $31,000. That range has only a 21% marginal tax bracket. For non-seniors, you are in a marginal tax bracket with an income over $37,000.

This means that RRSP’s have an advantage for those with working taxable incomes over $37,000 that expect to retire with an income between $15-31,000. This would apply to those with modest retirement savings, but not those with essentially no savings or to those with lots of savings.

These terms are very general, but “modest retirement savings” means something like $50-150,000 when you are in your 40’s and say $250,000 to $750,000 when you will retire. These figures assume retirement is 15 to 25 years from now.

There will be all kinds of variations for different people, but there are some rules of thumb:

Stage 1 Winner

The winner, generally, for each is people in these categories:

RRSP   – Reasonable working income and modest retirement savings or pension.

– High working income (over $120,000).

TFSA   – Low working income (under $37,000/year).

– Reasonable or high working income with very little retirement savings or pension.

– Reasonable or high working income with generous retirement savings or pension.

Stage 2

If you use an RRSP, what do you do with the tax refund? Getting a tax refund is the main reason many Canadians contribute to an RRSP. How you use it is critical for the TFSA vs. RRSP battle.

Based on the work of Talbot Stevens, there are 3 options for your tax refund:

1. Spend the refund.
2. Reinvest the refund to your RRSP.
3. “Gross-up” the tax refund.

To understand “gross-up”, let’s look at an example. If you have $10,000 to invest in your RRSP and are in a 50% tax bracket, you would need to contribute $20,000. Your tax refund would be $10,000, so you are net out-of-pocket $10,000, which was the cash you have available.

How could you do this? You could contribute $10,000 plus take a short RRSP loan for $10,000 (or use a line of credit). Use the tax refund to pay off the loan.

If you are contributing monthly and have reduced your tax at source (or are contributing to a group RRSP), then you are essentially doing the gross-up.

Let’s look at how these 3 options affect the TFSA vs. RRSP battle. Here, the point is most clearly shown when we ignore investment return (assume 0%) and look at only one contribution. For simplicity, we assumed a 50% tax bracket before and after retirement.

If you have $1,000 of available cash, here are your options.

TFSA vs. RRSP
	With 0% Return					With 10% Return
	RRSP only.	RRSP w.	RRSP w.				RRSP w.	RRSP w.
Year	Spend Refund	Refund	Gross-up	TFSA		RRSP	Refund	Gross-up	TFSA
0	$1,000	$1,000	$2,000	$1,000		$1,000	$1,000	$2,000	$1,000
1		$500				$1,100	$1,600	$2,200	$1,100
2		$250				$1,210	$2,010	$2,420	$1,210
3		$125				$1,331	$2,336	$2,662	$1,331
4		$63				$1,464	$2,632	$2,928	$1,464
5		$31				$1,611	$2,927	$3,221	$1,611
6		$16				$1,772	$3,235	$3,543	$1,772
7		$8				$1,949	$3,566	$3,897	$1,949
8		$4				$2,144	$3,927	$4,287	$2,144
9		$2				$2,358	$4,321	$4,716	$2,358
10		$1				$2,594	$4,754	$5,187	$2,594
Before Tax	$1,000	$1,999	$2,000	$1,000
After Tax	$500	$1,000	$1,000	$1,000		$1,297	$2,377	$2,594	$2,594

Stage 2 Winner

TFSA. Only if you consistently gross-up all of your RRSP contributions, does the RRSP match the TFSA. Few Canadians do this. If you spend the tax refund, you would be far ahead with a TFSA. Even if you regularly contribute your tax refund, the TFSA wins, but not by a wide margin.

Note that if you always contribute the refunds, you end up contributing the same amount over time, but you are always behind the TFSA because you invested later. However, with a 10% return, you are only about 10% behind the TFSA at retirement.

Overall Winner: TFSA vs. RRSP

Overall, the TFSA will win for about 80% of Canadians.

– If you will spend your tax refund, then the TFSA clearly wins in almost any scenario. Note this is what most people do.

– If you regularly reinvest the tax refund or gross it up, then you should go back to the stage 1 rules of thumb. The TFSA also wins in most categories in stage 1. However, RRSP’s do win in one large category that would include 1/3 to 1/2 of Canadians – those with a reasonable working income and modest retirement savings or pension.

– If you would be tempted to withdraw from a TFSA, since it will be so much easier than withdrawing from an RRSP, then the RRSP may be better for you.

– TFSA limits are only $5,000/year, which is too little for most Canadians to maintain their existing lifestyles after they retire. RRSP’s allow much more contribution room, unless your income is under $30,000.

Recommendation

After declaring TFSA the winner for about 80% of Canadians, the best advice, however, will be to use a combination of TFSA and RRSP.

The purpose is to end up with a taxable income in retirement between $15,000 (or $20,000) and $31,000. If you can, then you will be in a low bracket in retirement. Note these brackets will likely be increased for inflation every year, so the brackets may be about double in 25 years.

You can achieve this by having a “modest” RRSP and the rest of your savings in a TFSA. Therefore, you should aim for your RRSP to be no more than about $350,000 now, which would be about $750,000 in 20-25 years.

We find that when our retired clients have a significant RRSP or pension plus a significant nest egg that is non-RRSP, then we can plan their retirement income very effectively. We can decide how much to withdraw from each source each year. Large non-RRSP portfolios are not that common for Canadians, however.

Now that we will have TFSA’s, the goal will be to build up a good nest egg in both a TFSA and an RRSP. This will provide all kinds of planning opportunities to minimize tax after you retire.

All these planning opportunities provided by TFSA’s are the dream for financial advisors. This is why we consider the TFSA to be the best improvement in retirement income planning for at least 50 years.

Ed