I know it's past tax season now but you could always use
this knowledge for future years so I figured why not! Every tax season, there
seems to be a lot of talk about RRSPs and TFSAs. They are both great investment
vehicles to save up for your future but which is better?
To refresh your memory, here are a few key points we know
for each:
RRSP
Contribution room is 18% of your earned income (up to a
limit that changes each year), for most of us our "earned income" is
simply our employment income (no... unfortunately your investment incomes don't
count!). We also know that whatever you contribute during the tax year, you can
deduct that amount off the year's income and your money grows tax free within
the RRSP. When you decide to take it out before retirement, you're subjected to
withholding taxes AND the amount withdrawn increases your income in the year of
withdrawal. The good news is, those taxes withheld can offset some of your
increase in taxes owing. One of the main advantages or main point of using an
RRSP is to save now at a higher tax rate by contributing and deducting from
income, than what you would be taxed in subsequent withdrawals during
retirement (taking it all out before the end of the year you turn 71 yrs old,
or through periodic payments after converting your RRSP into a LRIF or annuity,
whatever choice it may be). Note: You must convert your RRSP to a retirement income
vehicle or take it all out by the end of the year you turn 71 yrs old.
TFSA
Each year you get another $5,500 of contribution room, this
number is indexed to inflation and will change in $500 increments only (that's
why it was $5,000 in the past few years). Note that whatever you take out, can
be put back in the following year. In a sense that contribution room is never
really "used up", it can be recycled unlike RRSPs, where once you use
the available contribution room, it's gone and does not get added back if you
withdraw any amount from your RRSP. TFSA also allows tax-free growth within the
account but the initial contribution is not tax deductible. However, any amount
you withdraw does not get included into income, nor is it subject to
withholding taxes.
So after all that technical garble, what's the conclusion?
Let's do a simple example, let's say we are contributing $10k now,
letting it invest over 30 years @ 10% annual return, then withdrawing it
in such a way that allows around $25k after taxes for your annual
retirement spending.
If your tax rate now
and after retirement are both in the lowest income bracket, (which
means you'll withdraw cash after retirement annually in such a small amount
that you'll be in the lowest bracket) then the total net amount of cash after
tax is the same in the end. BUT TFSA is still more beneficial because A)
you can take it out all at once without negative tax implications if you choose
to, because withdrawals are not taxed. B) TFSA room is recoverable upon
withdrawal, RRSP contribution room is based on earned income and therefore not
recoverable. As mentioned earlier, whatever you remove from an RRSP does not
get added back to your next year's available contribution room.
If tax rate now is not
in the lowest bracket but it will be during retirement, you will
end up with a higher total net amount in the end by using an RRSP. However, you
have to consider your flexibility/liquidity needs. Will you need the option to
take out the entire amount after retirement? The trade off is a smaller amount
in total when using a TFSA but you get this flexibility. What if your grown
children needs help with their down payment for a home? Taking a large sum out
of an RRSP may not be possible because you may've transferred it to a LRIF or
some sort of annuity. Let's say you did not convert your RRSP into a LRIF or
annuity yet and you could take a large sum out, then you're still faced with
withholding taxes and a steep tax rate because you're likely going to be in the
highest income tax bracket for taking out a large sum. In essence, using a TFSA
to get a slightly smaller total value at retirement might be worth it. This
would be a matter of personal preference of course. Maybe you want your kids to
learn the value of the dollar and refuse to help them with any big purchases!
Then you likely won't be seeing any big withdrawals during retirement, assuming
you got a great coverage from your health insurance.
So when is an RRSP a better option?
1)
You're not in the lowest tax bracket now.
2)
You don't see yourself withdrawing large sums
during retirement years.
3) You want to take advantage of income-splitting
through spousal RRSPs.
4)
Or if you have used up all of your TFSA contribution
room and you have no choice.
For more information or advice specific to your situation,
consult a seasoned Financial Advisor at your local bank. Try to get one with a
CFA designation or someone with some experiences under their belt. I just had
one at my local branch telling me the 2013 TFSA limit is $5,000! (False! It's
$5,500)
All the best folks, "May the 4th" be with you!
-TT
