The introduction of the Tax-Free Savings Account (TFSA) at the beginning of 2009 has been touted by many as the greatest financial innovation since Registered Retirement Savings Plans (RRSPs) were launched in 1957. Although there are numerous benefits inherent in owning a TFSA, it is not the only way of saving and many Canadians face the issue of whether to invest in a TFSA or an RRSP given that there is only so much that they can be allocate to total savings. Like most financial planning dilemmas; the best solution is based on understanding one’s potential options and the implications of each choice in the context of their individual goals and objectives.
To begin this assessment, the best place to start is looking at the similarities between the two savings vehicles. TFSAs and RRSPs are identical in 4 distinct ways: interest expenses from borrowing to invest are not tax deductible, only “eligible investments” can be held in these savings vehicles, there is a 1% monthly penalty for contributing more than the allowable limits and there are no taxes on annual investment income if invested in either vehicle.
The contribution room for TFSAs and RRSPs is one area in which there are significant differences. RRSP contribution room is calculated as 18% of one’s earned income (from the previous year) up to a maximum of $22,450 for 2011. Any amounts not contributed in past years are automatically carried forward but if one makes an RRSP contribution and then later makes a withdrawal, this contribution room will be lost forever. Additionally, one can not make contributions to and RRSP after the age of 71.
In contrast, TFSA contribution room is currently $5,000 per year for everyone over the age of 18, regardless of whether they earned any income at all. Like RRSPs, any unused amounts can be carried forward but a key difference between RRSPs and TFSAs is that any amounts that are withdrawn from TFSAs can be re-contributed in future years. TFSAs can also be contributed to at any age (above 18).
The second and most significant difference between TFSAs and RRSPs are how they are taxed beyond the tax deferral that occurs as mentioned above. RRSPs receive a tax deduction for any amounts contributed but all withdrawals are also fully taxable. Conversely, TFSAs are NOT tax deductible: however, they are not taxable upon withdrawal.
To illustrate these key differences, the example of an individual making $70,000 of income whom is considering contributing $15,000 to either an RRSP or a TFSA will be used. If this individual contributed $15,000 to an RRSP, their income taxes payable would be reduced by $4,455. In contrast, a TFSA would have no such benefit.
On the other hand, when these funds (that hopefully have had excellent returns) are eventually withdrawn from the RRSP, taxes will need to be paid on the withdrawn amount. If this individual was still earning $70,000, and they withdrew the original $15,000 contribution, taxes payable would be the same $4,455. However, if they were retired and not earning any other income, no taxes would be payable. Alternatively, if this individual was still working and received a raise to $110,000 of income per year, they would have to pay $6,105 in taxes. This is 37% more than the deduction originally received!!! As a result, RRSPs are most commonly used to provide an income in retirement. If this $15,000 were instead withdrawn from a TFSA, again there would be no tax consequences.
From a strictly numerical standpoint, the decision on whether an RRSP or a TFSA would result in the greatest benefit can be determined by what income tax bracket the individual is in when they make a contribution and also when they withdraw this money. If one is in a higher tax bracket when they make a contribution than when they withdraw the funds, RRSPs would result in a larger balance after being withdrawn. However, if the opposite is true and one is in a lower tax bracket when they make contributions than when they withdraw the funds, a TFSA would be more financially beneficial. Lastly, if one was in the exact same tax bracket when the contribution is made as well as when the withdrawal is made, the resulting balance after withdrawals would be exactly the same.
Although the decision on which investment vehicle would be the most beneficial from a financial standpoint may seem to be quite easy to make, one must consider numerous other factors. For instance, if the individual in the example above wanted these funds for a car purchase in 5 years, a TFSA may be more beneficial because the $15,000 can be re-contributed to a TFSA in the future but not to an RRSP. Additional considerations that should also be considered include: the income tax bracket of one’s spouse, if the funds will be used for education or to buy one’s first home, the age and income of the individual, the amount of flexibility required and the impact of this future income on government benefits (i.e. OAS, the Guaranteed Income Supplement, GST credits and the Age credit).
Like most financial decisions that one makes, the decision on whether to use an RRSP or a TFSA does not have to be an all or nothing proposition. One would likely benefit from utilizing both in their financial planning and the key here is considering one’s personal circumstances. Professional advice should be utilized to ensure that one maximizes their opportunities and avoids potential pitfalls.
Troy Peart BBA, CFP, CFA can be emailed at email@example.com. Your questions comments or suggestions for future articles are encouraged.