Sorry for the exclamation mark in this title, but many Canadians still need this point hammered home for them. Too many times these days I am hearing clients, friends, or family claiming the RRSP is a waste of time, and Canadians should only be using TFSA’s (Tax Free Savings Accounts) for retirement savings. This is just simply not true! Although the TFSA is a great option given to us by the government in 2009, there is still a practical use for the RRSP as the numbers just make sense. Ideally, just max out both RRSP and TFSA contributions every year, and then enjoy the golden years on your yacht somewhere south of Moose Jaw. Sadly, the majority of us working class Canadians simply cannot afford to do this, so we need to prioritize.
A general overview of the RRSP is that all contributions create a tax deduction based on your marginal tax rate, it grows tax deferred, and then amounts are taxed upon withdrawal. The TFSA contribution is made with after tax dollars and does not get a tax deduction, it grows tax free, and is not taxed upon withdrawal. Let’s not mistake this article for bashing TFSA’s, as anyone who thinks tax free growth and tax free withdrawals isn’t a great thing, then you might need to consult a doctor….BUT, that also doesn’t mean you should put them up on a pedestal over the RRSP either.
The general guidance of who should buy an RRSP is if you are in a higher tax bracket today while you are working, and a lower tax bracket when you are retired, then an RRSP is the right vehicle for you. So, what this equates to is saving more tax today on your contributions and then paying less tax when you withdrawal in retirement. If you are in the same tax bracket while working and expect to be in the same while retired, then typically it is said that an RRSP vs TFSA is just a wash. Since the tax you save today will equal the tax you pay tomorrow on it, then that is why people typically come to this conclusion. We will look at examples of when this holds true, and when it does not.
Here is a simple chart showing that TFSA contributions are made with after tax dollars, while RRSP contributions are made with pre-tax dollars, but withdrawals are taxed. This example illustrates someone who is in the same MTR during the contribution as they are during the withdrawal will end up with the same net withdrawal. This also assumes that we reinvest our tax refund instead of spending it foolishly. Good luck, right?!
Based on this chart with the same tax rates we can easily see that once someone is in a higher tax bracket now than they are in retirement, then RRSP should be the clear winner. But, if you think you will be in the same tax bracket in retirement and you find yourself struggling to reinvest those tax savings from RRSP contributions, then a TFSA might be the better option. But, things can get even more difficult when making this decision as how can we possibly know what tax bracket we will be in 30 years down the road, how much will tax rates be changed 30 years from now, will I be able to split income with my spouse, will I even have a spouse, or will the Roughriders still have a team? The future is highly unpredictable.
Let’s now examine the marginal tax rate and the average tax rate to make this more confusing. Your marginal tax rate is the amount of tax paid on an additional dollar of income. A big misconception is that a person pays taxes on your entire income based on your marginal tax rate. The total amount of tax paid is actually called your average tax rate where each portion of your income is taxed at a different amount based on the combined provincial and federal tax brackets and then averaged out to get your total amount of tax paid.
An example of someone earning $60,000 would put them in a marginal tax rate of 31% and an average tax rate of 25%. This is highly important, as you must not assume since you will be in the same MTR in retirement that you will actually be paying the same amount of taxes on your RRSP withdrawals. This will only stand true if you have other sources of income during retirement that put you in that MTR before you start withdrawing the RRSP’s. If you are receiving $60,000 in retirement income and $50,000 of it is coming from your RRSP, then you will not be paying total tax on those withdrawals based on your MTR, but rather a lower percentage based on your average tax rate. Using this example then shows the benefits of the RRSP over TFSA even if you are in the same tax bracket today as you are in retirement.
The TFSA is much more flexible as you can easily withdraw money and put it back later with no penalties or tax. Flexibility like this when saving for retirement may not be a good thing though. If people use the TFSA as “temporary” money to pay for trips, cars, or home renovations, and not actually put the money back in the TFSA, then it could be disastrous for someone’s retirement plans. If markets increase substantially by the time you even think about putting that money back into your retirement account, then that lost growth potential could have dire effects as well.
Sadly, there is no black and white answer when it comes to RRSP’s or TFSA’s as every Canadian has their own unique situations. Consult your advisor to help hash out a plan. Life changes constantly, and luckily your financial plan can adapt accordingly as well. To sum up, don’t spend your RRSP refunds foolishly and don’t spend your TFSA equally as foolishly. Easier said than done! Happy Saving!
-Marty Metz, CFP®
CERTIFIED FINANCIAL PLANNER
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