One of the biggest questions clients have is RRSP or TFSA? Which one is best for me?
Some advisors will spend hours and dive into analytical scenarios of your possible future to figure this out. I find that the answer to the question is better solved with a combination of math and lifestyle flexibility. I will show you what I mean down below.
Often, clients can’t afford to contribute the maximum in both savings vehicles so it becomes a choice either or; or a combination of the two.
A Tax Free Savings Account is a savings account introduced by the federal government in January of 2009. When you save in a TFSA, your investment earnings grow tax free. Unlike an RRSP, you do not receive a tax deduction when you contribute and you are not taxed on withdrawals.
Since 2009, the TFSA has become the more popular choice as people began to become more knowledgeable with the TFSAs features. The TFSA provides exceptional withdrawal flexibility because withdrawals are non-taxable and contribution room is only lost until the next January 1st. Withdrawals are also not income tested in which again presents it’s advantages in retirement particularly when planning around Old Age Security.
The biggest reason people would choose investing in an RRSP is when they think they will require less money in retirement than while they are working.
For example, a couple might require a household income of $150,000 while paying child expenses, paying off debt, and saving for retirement. When retirement comes, the couple should be debt free, therefore only needing money for utilities, property taxes, and lifestyle. Less expenses equals less income needs which means lower taxable income.
In other words, a couple might move from 45% marginal tax rates down to 30% marginal tax rates in retirement therefore saving a difference of 15% in taxes.
That leads us to scenario 1.
Scenario #1- Low tax brackets
If your income in retirement is going to remain close to the same as it is now, you lose the real benefit of RRSPs. You may as well as save yourself the headache of getting a tax break now only to give it right back in retirement.
This is very well the case for people earning less than $95,259*. At this income level, the Saskatchewan Marginal Tax Rate ((insert link https://www.taxtips.ca/taxrates/sk.htm)) jumps from 33% to 38.5%. This 5.5% jump is the largest increase in any of the marginal tax rates (ignoring the basic tax exemption levels).
For people earning less than $95,259 the tax savings if you contribute to RRSP will be so minimal that you may as well save yourself the time and contribute to your TFSA. Remember that TFSA withdrawals are non taxed and are not income tested for Old Age Security benefits.
Scenario #2- Emergency Funds & Major Purchases
You could park your emergency funds and money for major purchases in your TFSA if you have the contribution room AND it won’t delay your retirement. I hate to see clients get in the habit of using their TFSA savings for major purchases and emergency accounts because that will inevitably delay retirement. The easy access to money is potentially one of the drawbacks of the TFSA.
However, if you have the contribution room and your savings funds are limited, you could kill three birds with one stone by focusing all your savings into your TFSA. One way you could separate the funds is allocating the money into three separate investments. One for retirement, one for a major purchase, and one for emergencies. That way you can avoid dipping into your retirement savings.
Scenario #3- Pension Planning
Many people build up large defined contribution pensions or will benefit from high income defined benefit plans. It’s not unreasonable to have $750,000 in your PEPP (Public Employees Pension Plan) account if you have been a loyal employee. It is also not unreasonable to have a defined benefit plan paying you $55,000/year for life.
Both of these situations are great but it does lead to a tip-toe dance to keep retirement incomes under the OAS threshold. For 2019 that threshold is $77,580 of income per year. Sometimes going over this is unavoidable but as retirement planners, we try and get the maximum out of government benefits as possible.Pair your pension income with extra savings in RRSPs, and the task becomes a real challenge.
Which retirement portfolio would you rather have?
Portfolio 1- $750,000 Defined Contribution Pension & $250,000 RRSP
Portfolio 2- $750,000 Defined Contribution Pension & $250,000 TFSA
The answer is Portfolio 2 will only have $750,000 in taxable assets versus $1,000,000 in Portfolio 1. Portfolio 2 will make it easier to stay under the OAS threshold.
Also, there is nothing worse than wanting to go on a vacation in retirement and having to take out $10,000 in RRSP just to net $7,500 after taxes.
NOW, this is a severe over simplification but remember that this is the non technical version as stated in the title.
Scenario #4- Estate Planning
Just as the previous example in pension planning, the TFSA can also help lower your estate tax bill. Remember that on second death of a spouse, taxes have to be paid on the remaining assets in the estate.
In some situations, we can have the withdraw a higher income from the RRIF or PRIF and contribute the excess money into a TFSA. This strategy works when the client has TFSA room and excess registered assets that they don’t plan on using.
What you are effectively doing is reducing the potential estate taxes in the event of early death.
Scenario #5- Home Buyers Plan Alternative
This scenario is more of a personal preference of mine.
I like to use the TFSA when helping clients save for a downpayment on a home rather than the Home Buyers Plan.
The Home Buyers Plan allows first time home buyers to withdraw up to $25,000 from their RRSP to buy a house for themselves. Click here for all HBP rules ( https://www.canada.ca/en/revenue-agency/services/tax/individuals/topics/rrsps-related-plans/what-home-buyers-plan.html insert link). Then, the home buyer can repay the amount they withdrew over the next 15 years. Essentially a loan to themselves.
There are two problems here. One, now that you have purchased your home, you have most likely increased your cost of living with a new mortgage, taxes and utility costs- making it difficult to repay your HBP back.
The second problem is that because you contributed your down payment savings to your RRSP. You have locked in your tax deduction rate at the time you contributed. Many first time home buyers are in entry level jobs and expect their income to grow over time. It makes more sense to save your RRSP room for when your income increases- preferably higher than $95,259*.
As always, make sure you consult with a Certified Financial Planner to review your personal situation. These scenarios are common scenarios that I run into and should help you get some clarity when to choose saving in your TFSA versus your RRSP. The best scenario is do both!
If you would like some help figuring out which one will work best for you, book a call below.
*Tax Rates & OAS Threshold Rates are for 2019