Friday, 21 October 2011

RRSP vs TFSA? Critical Differences and Imponderables

Our last post compared the RRSP with the TFSA strictly on the basis of numbers - which generates the most after-tax income during retirement - and concluded that the TFSA is best for people earning below $37,000 during their working years while the RRSP is best for higher earners. Today we look at other features of these plans to see why that conclusion might not hold up.

Tax Rate Changes - Contribution vs Withdrawal
The RRSP gains a monetary bonus if the tax rate in retirement is lower than when contributions were made and it incurs a penalty if it is higher. The TFSA is completely unaffected by such a tax rate difference (since all contributions are made with after-tax funds and withdrawals are not taxable). In the section titled What happens when rates change? on his lengthy page on RRSPs RetailInvestor works through an example and concludes that "This effect (of a change in tax rates) is the major difference between the TFSA and the RRSP".

Most probably, figuring out whether your retirement tax rate will be higher or lower is well-nigh impossible for most people. On the same page under What are the unknowns that will determine a rate change? RetailInvestor lists many factors that can cause a change, such as: a large RRSP/RRIF (or LIRA/LRIF/LIF) balance at death that all becomes taxable income through deemed disposition tax rules and pushes RRSP income into higher brackets; big lump sum withdrawals for illness, long term care, round-the-world cruises that push RRSP withdrawals into higher brackets; non-registered investment income that might get boosted from inheritances or profitable sale of a home; government decisions to raise or lower taxes. As a result:
  • for top bracket earners ($120,000+) who stand a good chance of taking money out at lower tax rates, the RRSP solidifies its advantage
  • lowest bracket earners will almost certainly experience a rise in tax rates in retirement and thus should forget the RRSP and focus on the TFSA
Savings Discipline
Simply getting around to making contributions is a big psychological challenge for both the TFSA and the RRSP. It isn't the only one however. Each has its own pitfalls and each investor must figure out which ones he/she is most prone to fall prey to. This could be the key factor - obvious though such a comment might be, if you don't save and keep the money in the plan, it cannot grow.

RRSP - The Tax Refund Temptation
The first issue is that in order to get the full value of contributing, compared to a TFSA, the tax refund portion must, in effect, be invested as well. In one example from the TaxTips comparison calculator we used in our previous post, a $5000 RRSP (pre-tax) contribution was, for instance, only equivalent to a $3550 TFSA (post-tax) contribution (the actual equivalent amount varies according to your tax bracket). Put another way, if you have $5000 cash to contribute either to a TFSA or a RRSP but spend the RRSP contribution tax refund you will be far short of your retirement spending goal when the RRSP's deferred taxes have to be paid (see a detailed explanation in the TFSA vs RRSP comparison on Million Dollar Journey). TFSAs don't offer the temptation of the seemingly found money refund, which all too many Canadians succumb to. Score one for TFSAs.

TFSA - The Cookie Jar Temptation
In a recent GlobeInvestor article about TFSAs and RRSPs, Wealthy Barber author David Chilton said he feels the ease of TFSA withdrawal, greased by the thought that the money can be replaced the following year, which is not allowed with RRSP withdrawals, makes it more prone to the withdrawal temptation than the RRSP. Will Canadians delve into their TFSAs for luxury spending more than they have into RRSPs? That remains to be seen. Score a minor plus for the RRSP.

Tax Management
The TFSA has several significant post-retirement tax advantages:

TFSA withdrawals do not count for income-restricted benefits such as OAS and GIS.
  • When you need a bigger lump sum of cash in a particular year e.g. for that cruise, home renovations, health costs, gifts, new car etc, a bigger RRSP/RRIF withdrawal can push you into a higher tax bracket and reduce or eliminate GIS or OAS.
TFSA allows contributions up to any age
  • In contrast, the RRSP must be converted to a RRIF or an annuity i.e. be progressively withdrawn starting by age 71 at the latest. This TFSA feature is very useful to gain tax-free earnings from investing surplus funds, such as on-going cash not needed for current living expenses or perhaps an unexpected lump sum like an inheritance. The cumulative, non-expiring annual $5000 contribution room of a TFSA enhances this advantage. You cannot put inheritances received into a RRIF.
  • Example - Putting these factors together, suppose you withdrew $30,000 extra during retirement from a RRIF, pushing you from $36,000 taxable income to $66,000 that year. That would cost about $10,000 more in taxes for an Ontario resident. Suppose a year later, you received a $30,000 inheritance, you could not put it back into the RRIF. Your choice would be to invest it in a regular taxable account, subject to tax every year, or into a TFSA if you had the contribution room. With the TFSA, the money would come out with zero effect on taxes and the withdrawal would create $30k in contribution room, permitting you to return the inheritance money to tax-free gains.
TFSA simplifies income splitting between couples to lower overall tax
  • Income splitting is easier with the TFSA since both spouses automatically get $5000 in annual contribution room and one spouse can contribute up to that limit to the other's account. With the RRSP, the receiving spouse must have available contribution room built up through earnings, a problem when one spouse is a low- or no-income earner.
TFSA is simpler to manage and figure out.
  • With a RRIF you must content with: having to pay attention to forced RRIF minimum annual withdrawal amounts; and figuring out the net cash available immediately upon withdrawal after witholding tax (from TaxTips) or after tax filing, which amounts will probably differ, for withdrawals above the minimum from a RRIF. With the TFSA, to use the hoary phrase "what you see is what you get". There's no confusion or uncertainty. The amount you withdraw is what shows up in your bank account to spend. There are no tax implications to figure out, things to file in a tax return or later amounts due or refunds. Life is simple, as it should be.
RRSP/RRIF qualifies for Pension Amount
  • One plus of the RRSP is that withdrawals from a RRIF qualify, if you are 65 or older, for the $2000 pension income tax credit (see Canadian Tax Resource's What is Eligible Pension Income? for details). TFSA withdrawals do not qualify.
RRSP/RRIF Witholding Tax superiority
  • Since the US government recognizes only the RRSP/RRIF and not the TFSA as a bona fide retirement account, 15% US-government levied witholding taxes eat away at returns on US-listed ETFs, as we wrote about in Pros and Cons of Cross-Border Shopping in the USA for ETFs. That penalty for TFSAs applies pre- and post-retirement and across all income levels and would also apply to US-listed equities paying dividends or bonds paying interest. That can make a significant difference to returns on such holdings in the long term, as we noted here.
Bottom Line
  1. Highest income earners of $120,000+. Focus on the RRSP first due to the likelihood of a drop in your tax rate. If the RRSP contribution room isn't sufficient for savings goals, put any extra in the TFSA. After retirement the TFSA makes a fine parking spot for surplus funds.
  2. Income earners below $37,000. Focus exclusively on the TFSA. If you are frugal enough to save more than the $5000 contribution limit, then look to the RRSP.
  3. In between $37k and $120k. Save through both TFSA and RRSP to gain the advantages of each and the flexibility of having both.
Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.


Anonymous said...

Thank you! Helped me confirm the facts.

Anonymous said...

I came across a situation where a high income earner had all of his life savings in RRSP. This meant that at withdrawal/RIFF time, he would be still in a high tax bracket AND OAS clawback would apply to him.
Thus I thought that he should be maximizing his TFSA so as to (1) be able to have emergency funds AND (2) declare retirement income below the clawback threshold. But it is a tricky situation given that RRSP contributions reduce taxable income.

CanadianInvestor said...

Anon, given what you describe, when you cannot be sure that you will be in a lower tax bracket (which as we define it includes effects on OAS, GIS and pension amount) the balance shifts to not exclusively using RRSP even for highest income earners. TFSA's usefulness for things you mention like the emergency fund do enhance its attraction.