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moneysense.ca, 26/01/11
The Advantages of RRSPs over TFSAs
It is undeniable that Tax-Free Savings Accounts (TFSAs) have unique advantages but I’m somewhat surprised by some recent reports that suggest that a lot of Canadians would be better off contributing to a TFSA instead of a RRSP. These arguments forget to take into account the unique advantages offered by RRSPs.
Defer income taxes
RRSPs allow taxpayers to defer their income tax obligations to a future year. Taxpayers with wildly fluctuating incomes can smooth out their income tax obligations by contributing to a RRSP in fat years and withdrawing from it in lean years.
Income splitting
When one spouse earns a much higher income than her partner, she can take advantage of income splitting opportunities offered by RRSP accounts. She can contribute to a spousal RRSP and get her income taxed at the hands of the lower income spouse. She can take advantage of income splitting available to seniors who withdraw from a RRSP or RRIF. The tax benefits of income splitting can be substantial.
Increase in income-tested benefits
It is true that withdrawals from a RRSP or RRIF may result in a reduction of income-tested benefits. But the flip side is often neglected. Contributions to a RRSP reduce one’s taxable income and increases income-tested benefits such as the Canada Child Tax Benefit.
Here’s an example. An Ontario couple with two children, earning $50,000 each will receive an annual CCTB of $335. If the couple contribute $9,000 each to their RRSPs their CCTB payments will increase to $1,055 per year.
Shelter foreign investments from tax
Investors who hold globally diversified portfolios should hold their US equities and US-listed ETFs in their RRSPs. Dividends from foreign equities in taxable accounts are taxed at marginal rates. US stocks and ETFs held in TFSAs are dinged a 15% withholding tax. When held in RRSP accounts, these assets are sheltered from tax until withdrawal.
moneysense.ca, 26/01/11
Thank you. I was beginning to think the world was against RRSPs given all the articles that seem to be giving the edge to TFSAs over RRSPs. Great thoughts here!
My simplistic advice is to fill the TFSA first: if you’re in a lower tax bracket, the TFSA will be superior, and you’ll get all your savings in there. If you’re in a middle tax bracket, you should be saving more than $5k/year anyway, so the first bit will go in the TFSA, and the rest in an RRSP, which isn’t bad for the middle tax brackets — kind of split the difference when it’s a bit of a toss-up anyway. For the highest earners, filling the RRSP first may be slightly more efficient advice, but if they’re savers then both tax shelters will in all likelihood get filled anyway.
Plus optimization aside, the TFSA has simplicity on its side: if you’re too aggressive with your savings and need to get some money back out, you can do that with the TFSA and get your contribution room back. And there’s no need to hunt for last year’s NoA to find out how much room you have. Just wait until a new year, and then put in $5k (or, for the future, the inflation-adjusted figure the media and banks will no doubt saturate you with).
TFSA FTW!
[But yes, if you do have a situation for income-splitting, expect to be in a lower tax bracket, then the RRSP will be better, and everyone has to make up their own minds]
“Defer income taxes”
Hooray, buy now! Pay Later!
“Income splitting”
No attribution through TFSA withdrawals makes this point moot. Both plans can do this.
“Increase in income-tested benefits”
Hooray, buy now! Pay Later!
“Shelter foreign investments from tax”
This one is the only point that really holds up in my opinion.
Glad to see someone going against the mainstream. As potato says, “If you’re in a middle tax bracket, you should be saving more than $5k/year anyway”, but I would further state if you run numbers for a middle to upper class Canadian and they have pension splitting, in most cases you would have a 40-46% deduction on the RRSP and only a 20%-25% tax coming out, thus the RRSP maybe beneficial in the first place vs the TFSA.
There are indeed instances when the RRSP makes more sense than the TFSA.
I am curious what you think about the following scenario:
Couple, both public servants with government pensions earning ~$150,000 combined, pre deductions.
Their income is not super high but definitely not low.
Given the pension income at retirement, is TFSA maximizing more advisable than RRSP maximizing? Which would you max out first?
I wonder about the people who use their TFSAs for “gambling” to see what kinds of returns they get if they’re lucky and happen to pick stocks that do well. I’ve heard stories of people parlaying $5,000 into $20,000 or more. In cases like that, wouldn’t a TFSA be better, since with an RRSP all of that gain would be taxed and you’d only get a deduction on the $5,000?
Thanks to CC for another perspective on this debate…is it just me or does it seem to have taken on the same undending cycle as the pay debt or RRSP one?
Thanks also as usual for the interesting comments from other readers and the SIMPLE advice from Potato. I will be keeping his approach in mind as I go forward.
Sometimes it becomes information overload for us (albeit trying to self-educate) civilians. Like a good murder mystery just when you think you’ve got a handle on the plot line…a twist!
One other advantage is that it is easier to get money out of your TFSA compared to the RRSP. Doing the withdrawal from an RRSP is no problem, but you have to pay withholding tax and you lose the contribution room. No such penalty for TFSA.
In my mind this is actually an advantage for the TFSA, however for a lot of (undisciplined) people – the RRSP might be a better choice if they are more likely to leave the money alone.
I never really understood the desire to find the ‘optimal’ strategy. If I had to choose (i.e. couldn’t max both), then I would continue to use both, most likely evenly. I think there are very few people who fit into a category where maxing one account type first is a clear advantage (e.g. extra high or extra low income). For everyone in between, who can say what their future incomes will be? who can say whether some unexpected event throws a wrench in those plans?
People always seem so concerned they will pay more tax upon requirement because their RRSPs are too large, well I look forward to that day, because perhaps I can retire 1, 2, heck even 15 years early.
Hedge the risk of being in a sub-par situation, put money in both!
Off topic but someone tell me how to get the comments section to print?
I agree that RRSPs are usually better in the long run, but choosing the TFSA now lets you defer the debate until you are closer to retirement. By this I mean that you can easily move TFSA money to an RRSP when you are older, but the reverse is not true. Additionally, you are likely to be in a higher tax bracket later in your career and can reap more benefit from RRSP contributions (if you in fact decide that RRSPs are better).
DG
@Jim Yih: I am a bit surprised with all the anti-RRSP articles too. Weren’t these same financial institutions scaring people to max out their RRSPs?
@Potato: Fair enough. Contributing too much to a RRSP isn’t a problem for the vast majority. For those who did contribute too much in the past, it may not be as convenient as a TFSA to cut back but it isn’t impossible either. They can stuff the RRSP to the gills with low-growth assets, ease back on new contributions or simply retire early and enjoy their savings. It is a very nice problem to have!
@Traciatim: I personally like to defer tax liabilities as much as I can. Income splitting opportunities afforded by RRSPs could be much greater than the TFSA.
@the blunt bean counter: I agree. Dropping from the top bracket to a mid bracket will result in substantial tax savings.
@Sustainable PF: Of course, there are many individuals for whom TFSAs will make sense. My spouse is a civil servant too. And for her there isn’t much RRSP contribution room anyway due to the pension adjustment. For civil servants who are going to have their retirement funded by a Govt. pension, TFSAs makes perfect sense as a first choice.
@brad: I disagree. Let’s say an individual in the 40% tax bracket contributes $8,333 instead to a RRSP. She also quadruples her capital to $33,332. She withdraws from her RRSP, pays tax at her 40% marginal rates and she will be left with…. tada! $20,000. I’ve made assumptions here about marginal rates remaining the same. But they could be different, in which case the TFSA or RRSP will win out.
@marie: Sorry for adding to the information overload. I guess I thought all the negative RRSP articles need a counterpoint. I suppose it is important to save something whether in a TFSA or a RRSP. Which one would turn out to be better? Ask us when we are retired and drawing down from the accounts!
You can copy, paste the comments to MS Word or similar software and print it out. I’ll have to investigate if there is way to print the comments.
@Money Smarts Blog: I don’t deny for a moment the unique advantages of TFSAs. Having said that I expect to see TFSAs seeing a lot more withdrawals than a RRSP, simply because it is easy to do so. Those of us who are PF nuts may find it easy to resist the temptation but my guess is most people will find it irresistible to tap retirement savings in a TFSA to pay for that cruise.
@Sampson: Excellent point. Any discussion on an optimal strategy involves some very shaky assumptions. Who knows what tax rates, RRSP rules and TFSA rules will be in the future? Perhaps one compromise could be to contribute to one account one year and the other the next. Or if at possible make equal contributions to both when it is not clear which one will win out.
@DG: I agree. Those young and just starting out may be better off with a TFSA and can decide on a RRSP later in their life.
@CC: Thx for tip for comment printing. BTW I wasnt including your article in the info overload reference. I actually did appreciate a counter opinion to the almost anti-RRSP ones out right now. I meant in general, for some of us, it can start to feel like info overload. I also tend to create it for myself at times by over exposing myself to various sources of info as they come out. My goal is a more balanced view of investing and retirement but like most things in life I over indulge at times and get a headache!
Cheers
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The one benefit of an RRSP that no one seems to talk about is the present value of the tax savings generated by contributing to an RRSP. If you defer the tax on the original contribution for 15 to 20 years, the present value of the future tax payment to be made on withdrawal is nominal. In current dollars, you’ve effectively eliminated the tax cost. I think this alone swings the debate in favour of maxing out your RRSP first. The benefit from deferring taxes for a long period of time is huge.
In the last paragraph you talk about Canadians in low, middle and high tax brackets. What do you define as low, middle and high tax brackets and does it include the household income (i.e. of 2 spouses) or the income of each spouse?
Please advise.
Thanks
@Kim: Actually, that’s not quite true because on withdrawal you pay tax on the original contributions plus the growth of those contributions over the years. Whereas, in a taxable account, the tax paid on investment growth and dividends is tax advantaged. Regardless, I do expect the PV of future tax liability to be much less because I fully expect to be withdrawing at lower tax rates (assuming current tax rates hold, which I grant is a huge assumption).
@Lisa: An Ontario resident earning less than $37,000 pays tax at a rate of 20 percent. If I were in such a bracket, I wouldn’t bother with a RRSP. Anyone earning $77,000 or more is in the 40% or higher bracket. They may be better off contributing to the RRSP first. These tax rates are for individuals. The analysis is slightly more complicated for a family. An Ontarian earning $80K with a stay-at-home spouse is almost certainly better off contributing to a RRSP. Why? Because in retirement, she can split her income with her spouse and drop into the low bracket.
Assuming an individual’s marginal tax rate remains constant (factoring clawback of income test benefits), mathematically, the RRSP and TFSA are equal (i.e., your after-tax income in a RRSP will be equivalent to what you would earn in a TFSA).
If you are already in the highest tax bracket, then the RRSP is probably the better bet since you will not pay tax at a higher rate when you withdraw it (barring tax increases), and more likely a lower rate given the income smoothing qualities CC mentioned. If you are in the lowest tax bracket, then the TFSA is the better bet. I hope all advisors are trained to communicate this, recognizing that there are always exceptions to the general rule.
Some of my friends tell me that their advisors say the TFSA is superior since RRSPs have a pending tax liability, but that is not the case when you do the math.
The RRSP and TFSA are two sides of the same coin: pay tax upfront or defer and pay tax later plus the time value on the money deferred.
I think there are a lot of people that contribute to RRSPs just because it seems like that is what they are supposed to do to have retirement savings, and don’t realize that is their income is low, it might not be the best choice. Hopefully the articles promoting TFSAs have at least made more people think about the options and why they may or may not want to contribute to their RRSP account.
@CC: I understand, but if you use the after tax return on the earnings as your discount rate (without factoring in any PV savings from the deferral of tax on the earnings), my guess is that you will still get a relatively nominal current tax cost on the capital even if you’re paying high rates at withdrawal. On a PV basis and assuming a long term hold (this is critical), my gut tells me that you’d still be further ahead by investing 100 cents on the dollar in a tax deferred account (RRSP) rather than 70 – 80 cents on the dollar in a tax free earnings account (TFSA). Your rate of return in the tax free earnings account would have to be pretty high to make up for the loss of initial capital.
[...] Canadian Capitalist says that RRSPs are not so bad after all. [...]
I don’t think maximizing your RRSP makes much sense. We’re optimizing our RRSPs, not maximizing them, only putting enough cash into them to avoid paying any additional income tax every year. Even though my wife and I are fortunate to have good jobs, we don’t see a huge value in socking away hundreds of thousands over 30 years only to be taxed on it at a later date. Why not maximize the TFSA and optimize the RRSP? That’s our strategy. It doesn’t have to be one or the other unless you’re in a low income bracket during most of your working career, then the TFSA clearly wins in my opinion.
@CC. I don’t know about that… If I were in the 20% tax bracket, using an RRSP would still reduce my taxable income and thereby provide a 20% return in tax credits… Assuming that when I’m retired, my earned income would go to zero and I can withdraw my RSP money at a rate which is below my basic exemption and thereby get it essentially tax-free… So, in effect, that would be like getting an immediate 20% investment return on that cash up front, plus whatever the future investment gain might be.
To me, a 20% is a pretty healthy ROI right off the bat! It’s definitely nothing to sneeze at! For example, I recently sold off some Manulife shares for a 20% capital gain and walked away extremely happy. Imagine getting that 20% return but without the risk of holding onto some volatile Manulife shares!
In my actual case, I maximize both my RRSP AND my TFSA, plus I still continue to invest in a fully taxable account – so it’s really kind of a moot point for me. I’m just saying that even in a 20% tax bracket, the benefit of an RSP is nothing to sneeze at!
I am actually surprised by the number of people suggesting TFSA for lower income earners over the RRSP. Regardless of the best intentions of investors, the problems with using the TFSA for retirement is that the money is just simply too easy to accees. You can take it ourt without penalty and the temptation will be there to use it for a new car, house, expenses, renos, etc. So if someone in their 30s indicates they plan to use the TFSA for retirement, it would be shocking if that easy to access money is still there 35 years later.
[...] Canadian Capitalist looks at the advantages of RRSPs over TFSAs. [...]
Phil S – The personal exemptions and age credit only add up to something like 16K, you you’ll be making somewhere near 6-8k from CPP anyway. That means you’d only be able to pull 10-12K out of your RRSP each year. Plus, earning income from the RRSP in retirement will mean that GIS will be clawed back at 50 cents on the dollar if I’m not mistaken. I think it would be far better to have the TFSA income and not give back half your benefits.
@Traciatim
You are indeed mistaken. Assuming the earnings at retirement you’ve suggested, there is no way it will be enough to the point where GIS will be clawed back at all. The threshold is somewhere in the neighbourhood of around 66K from what I recall.
Ah, sorry, my mistake. I jumped the gun and got GIS confused with something else. Small increments of income up or down do indeed affect monthly payments in a fairly big way I’d say. And anything that exceeds $16,559.99 ($21,887.99 for spouse/common law-not including OAS payments) will erase your GIS entirely.
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