Planning for retirement starts with the basic principle of setting aside money for the future. The concept is simple, however the practice and practicality of applying it, is not easy. There are numerous statistical data reporting that many Canadians are not contributing to their Registered Retirement Savings Plans (RRSP), nor are they taking advantage of the Tax Free Savings Account (TFSA), and those nearing retirement have no formal retirement plan. The government is in the process of introducing yet another new plan. The Pooled Registered Pension Plans objective is to encourage savings for retirement for small business owners and their employees. These pension style savings will be government-regulated, private-sector funds aimed at the small business owner, as an option, to provide retirement savings for the employees of their company, similar in structure to Defined Contribution Plans. Other plans include Defined Benefit Plans, Group Retirements Savings Plans, Individual Pension Plans and Employee Profit Sharing Plans.
Is it any wonder Canadians are confused as to where, what or how to save. Let’s examine the most common individual plans, the RRSP and TFSA.
In building comparisons with the RRSP and the TFSA, I like to demonstrate the analogy to purchasing a vehicle. To establish which vehicle will deliver the better mileage and be the most reliable for you is dependent on a number of factors.
The benefit with contributing to an RRSP is the tax deduction while in higher income earning years. The annual allowable contribution to an RRSP is calculated at 18% of the prior year’s earned income, up to a max $22,400 for 2011. You would have had to earn a salary of $124,722 in 2010 to contribute the maximum for 2011. The tax savings would be $9116.80 at a marginal tax rate of 40.70%. The investment earnings inside the registered plan are tax deferred until age 71, whether it be earned as interest income, dividends or capital gain. At such time, the RRSP must be converted to a RRIF, where money is withdrawn and taxed as income at the marginal tax rate. The premise behind deferring the tax, is that less income will be needed at time of retirement, therefore expecting to pay less tax overall.
Therefore this vehicle could prove better mileage, a higher maximum allowance plus prospect of greater growth, at a reduced tax rate.
The TFSA is a registered savings account plan. To be eligible you must be over 18 yrs of age, a Canadian resident and hold a SIN. Contributions are made with after tax dollars, there is no tax deduction. The annual allowable contribution has been $5000 per year since 2009. The benefit with a TFSA is the investment can grow tax exempt. And more importantly, no tax will be applicable when the money is withdrawn.
TFSA is not income tested, which means that Old Age Security(OAS) and the Guaranteed Income Supplement(GIS) would not be reduced or clawed back if you accumulated a lot of growth within the TFSA and withdrew it at retirement, whereas income from an RRSP/RRIF , pensions or other investments could reduce your OAS /GIS benefits. Therefore, this vehicle could be more reliable, calculating how much income you could expect during retirement.
Most Canadians have a limited amount of money to invest after paying for the essentials in life, food, shelter and clothing. Ideally, one would wish they had the resources to annually max out contributions to the RRSP and the TFSA. If paying less tax overall is the purpose of using either of the vehicles, which then is better?
General factors to consider when a TFSA makes better sense:
1. If you are in a low income bracket, just starting out in your career, have student loan interest deductions or business expenses to write off to reduce your tax obligation, it is better to put your money into a TFSA. This will enable you to accumulate RRSP contribution room which could be used to save future taxes when your income increases.
2. If the investment is for a short term goal, i.e. saving for a vacation, the TFSA will allow you to grow the money, tax exempt and withdraw tax free. You will also be able to contribute all the money withdrawn back to the TFSA the following year.
3. You have been contributing to your RRSP for years now, you are single and you expect your income will continue to be in the higher tax bracket when you reach retirement, therefore invest in the TFSA first.
When an RRSP first, might make better sense:
1. Your marginal tax rate is at or above 30% and the refund cheque (tax savings) could be reinvested into TFSA, RRSP, your practice or pay down debt obligations.
2. You have some money set aside for a down payment on a home which you plan to purchase in the future. It would be wise to invest in the RRSP and take advantage of the tax savings if you are a first time home buyer. The Home Buyers Plan (HBP) allows you to withdraw the RRSP money to buy a home and not pay the tax, however the money will have to be repaid back to your RRSP in equal instalments over 15 years. The HBP allows up to $25,000 to be used.
3. You have been contributing to your RRSP for years now, your spouse has a defined benefit pension, and the new pension splitting rules may lower your tax bracket in retirement and allow you to avoid the OAS claw back. The RRSP with its tax refund may be in your favour.
The most common statement I hear is, “I think I should get an RRSP”.
Remember the RRSP and TFSA are plans; they are vehicles to help you collect your savings for retirement. What is the purpose of your vehicle? Where do you want the vehicle to take you? How fast? How far? What type of fuel will it need? Your vehicles performance will be dependent on the types of investments it runs on. Eligible investments include cash, GIC’s, bonds, stocks, mutual funds, mortgages, ETF’s, certain annuities, and gold, silver bullion.
There is no simple rule or answer to confirm which type of vehicle is better. Both plans have limitations, rules and are subject to penalties for over contributing.
Published in BCNA Bulletin Winter 2011
The information in this article are presented for general knowledge and the content should not be relied upon as containing specific financial, investment, tax or related advice. It is recommended to consult independent financial advice to discuss personal circumstances before implementing any type of arrangement.
Mutual funds provided by Sindy Billan as a mutual fund representative with Investia Financial Services Inc. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.