Lately, one question clients are asking me is whether they should contribute to a Tax Free Savings Account (TFSA) or a Registered Retirement Savings Plan (RRSP)? Personally, I really like the TFSA, however it doesn’t have to be an either or choice. Why not do both? If both, in what proportion should you divide your contributions? In order to make an informed decision, let’s quickly review the main features of each program. I will use bullets to illustrate the features as nothing gets people’s attention more than bullets.
TAX FREE SAVINGS ACCOUNT
REGISTERED RETIREMENT SAVINGS PROGRAM
Now that we have reviewed the provisions of each program, let’s try and analyze what program works best for us and in what proportion.
Both programs provide for no tax on the earnings on the contributions, no difference there. However, only the TFSA allows for withdrawals with no tax – EVER. If you are not reinvesting the tax savings generated from your RRSP contribution, the only thing you gain is an increase in consumer spending created by the tax saved. The truth is, however, that the tax deferred is really a loan from the government. Although, they don’t charge interest on this loan, the loan must be repaid at some point in the form of taxes on withdrawal. And like most things in life, that point usually comes when you can least afford it, like when you quit working, or require funds for an emergency.
Be careful not to over value your RRSP balance. It is important to remember that the balance will be reduced by the tax payable. If you are certain that you will retire in a lower marginal tax bracket than you are now, then the RRSP makes some sense.
This is also true if you routinely reinvest the tax savings but otherwise, at the end of the day, there is no difference in the final results of the two programs. This can be illustrated in the table below:
TFSA |
RRSP |
|
Pre Tax Earnings Deposited |
$ 5,000 |
$ 5,000 |
Tax |
2,000 |
N/A |
Net Contribution |
3,000 |
5,000 |
Value 20 years later at 5% growth |
7,960 |
13,266 |
Tax on withdrawal (40%)* |
N/A |
5,306 |
Net Withdrawal |
7,960 |
7,960 |
*marginal tax rate pre and post-retirement
Both programs lend themselves very well to each other. If you refer to the features of each listed above, the RRSP’s have to be converted into income starting no later than the contributors age 71. Assuming retirement at age 65 (yes, some people still do that), there are 6 years that bridge income will have to be provided, and what a better way than to have that income paid from a source that is completely free of tax (TFSA)? At the same time, the requirement to pay tax on withdrawing from an RRSP helps to ensure that those funds will actually be saved for retirement. RRSP’s were never designed to be a “rainy day fund”, but that purpose is well served by a TFSA.
If you can contribute the maximum to both – GREAT! If not, you should still take advantage of both programs. Try to establish a ratio of contribution that you are comfortable with and go with that. Remember, you can always change the ratio from one year to the next, and whatever plan you don’t maximize this year, your contribution room going forward will allow you to catch up later.
While the rules governing TFSA’s are relatively simple, this is not true with RRSP’s and is beyond the scope of this article. It is best to fully discuss the benefits and restrictions of each of these options before investing. Let’s talk and see what’s right for you.
Ong Financial Planning Services Ltd.
John Ong, CFP, CHS, CPCA, CCS
Financial Planner
Tel: (604) 676-1088
Email:
1275 West 6th Avenue 3rd floor
Vancouver, BC
V6H1A6