Not that long ago, most of us associated retirement savings with the venerable registered retirement savings plan (RRSP). But in 2009, a new option came along: the tax-free savings account (TFSA).
Though the RRSP has been around for decades and the TFSA for four years, Canadians are still confused about the differences between the two and what is the best investment option, says Andrew Guilfoyle, a Toronto financial adviser with Guilfoyle Financial and member of Advocis, The Financial Advisors Association of Canada.
“It’s a matter of your age, your stage and income,” Mr. Guilfoyle says.
First, it’s important to know the key differences between the two vehicles. With an RRSP, you can use your contributions as an income tax deduction and might receive a refund each year. You can contribute up to 18 per cent of your earned income a year to an RRSP, up to maximum of $22,970. However, when you cash in your RRSPs in the future, they are treated as earned income and you’ll pay income tax on them. The premise is that, in retirement, most of us will have a lower income, so our RRSP withdrawals will be taxed at a lower rate than during our working lives.
With TFSAs, you can invest $5,500 each year (up from $5,000 last year) regardless of your income. While you receive no tax deduction now, when you take out the funds, you won’t pay any tax on the withdrawals, nor will they affect government benefits such as Old Age Security.
While the RRSP is intended specifically as a retirement savings plan, the TFSA can be used to save for anything: retirement, a home or a new car. The investments inside either an RRSP or TFSA can be almost identical and you can buy such products as stocks and bonds, guaranteed investment certificates, mutual funds, mortgages, or you can set up a high-interest savings account. You can use a financial adviser or direct the funds yourself.
The freedom to access a TFSA at any time can be one of the pitfalls, Mr. Guilfoyle says. While many people have good intentions to use a TFSA to save for retirement, they often don’t.
“A lot of people still view a TFSA as a bank account or ATM because there are no penalties to access it. They may have saved this year, but then decide they want a trip to Mexico and take it out and spend it. It’s tough to imagine anything at just $5,000 a year amounting to anything when people use them as piggy banks,” Mr. Guilfoyle says.
That’s why he likes RRSPs, which can’t be cashed in without tax repercussions.
“For a Canadian without a pension plan, an RRSP that you let compound for 20 years is an incredible wealth-building vehicle that is going to provide you with dignity in your older years. Having an extra $100,000 in your retirement years is going to allow you to be so much more comfortable,” he says.
But Jeffrey Wellwood, an investment adviser with RBC Wealth Management/RBC Dominion Securities, is a fan of TFSAs.
“I think only about 50 per cent of Canadians have a TFSA and it’s the best thing since sliced bread for many reasons,” Mr. Wellwood says. “Obviously, the growth on investments is tax-free and you can take it out any time.”
Mr. Wellwood says a lot of people don’t understand how tax rates work. You might not be taxed at as high a rate as you think you are, so you may not need the RRSP contribution deduction. The marginal tax rate for $120,000 is 43.4 per cent, for example, but tax rates are tiered and not all your income will be taxed at that rate; 29.4 per cent is the average rate for Ontarians making $120,000.
“Most people want the tax deduction today. All RRSPs are taxed as income and many people don’t plan in advance as to what their income will look like in retirement,” Mr. Wellwood says.
Mr. Wellwood says it’s hard to predict what’s going to happen in 10, 20 or 30 years as to what your taxable income will be, what tax rates might be, or if rules regarding clawbacks will change. Most of us will make less once we retire, but if your retirement income is higher than it was during your working life, you could be heavily taxed or be subject to clawbacks of Old Age Security Pension (currently subject to clawbacks for incomes of more than $70,000).
“While RRSPs are great vehicles for saving for retirement, you need to seek advice from an adviser to determine if they’re an appropriate investment vehicle for drawing income from,” he says.
It’s also worth considering what happens to the money if you die: If your spouse is the beneficiary for either an RRSP or TSFA, there is a tax-free rollover to them upon your death. But when the remaining spouse dies, taxes will be due on any money left in an RRSP and heirs will get what’s left only after taxes are paid. With a TFSA, only the increase in the value of the TFSA since the date of death is taxed in the year the heirs inherit it.
It’s important to consider this, says Mr. Wellwood, as most of his clients still have money left in their RRSPs (or a registered retirement investment fund or annuity that they have to be converted to by 71) when they die.
Both advisers say lower-income Canadians are likely best to invest in a TFSA.
“Once people earn more than $60,000 or $70,000, it’s likely best to invest in RRSPs,” Mr. Guilfoyle says. “Under $60,000, it’s tough to come up with an argument that they are more worthwhile because the tax rates are lower.”
Mr. Guilfoyle offers the hypothetical scenario of a family of four: The 50-year-old doctor husband has incorporated his medical practice and pays himself enough to live on through dividends, which are taxed at a lower rate than a salary. The excess, which otherwise may have gone into RRSPs, is reinvested in his corporation. At retirement, he’ll sell his corporately held investments and take the after-tax proceeds. His wife, 50, has a full-time job. Their 23-year-old son has graduated from postsecondary education and just started working while their younger 20-year-old child is in university.
Because the doctor takes what he needs in dividends, he might not need to make any RRSP contributions. His wife, however, should maximize her RRSP contribution while the 23-year-old should start a TFSA. The 20-year-old, still in school, doesn’t have to do anything just yet.
Every case is individual, Mr. Guilfoyle says. For instance, parents with children have to also consider registered education savings plans to save for postsecondary education or, if they have a disabled child, a registered disability savings plan.
What both advisers agree on is this: It’s more critical than ever to save for retirement.
Mr. Guilfoyle points out that in 2013, fewer Canadians than ever have pension plans. According to Statistics Canada, about 60 per cent of Canadians have workplace pension plans.
“With our parents’ and grandparents’ generations, most worked for one company for their whole life and had their pension supplemented by government income,” he notes. “Even people in the corporate world now transition every so often and their pension plans aren’t going to be like their parents’ plans. Anyone in the private sector under age 60 isn’t going to have that.”
– Annual contributions are tax deductible.
– Withdrawals are taxed as earned income.
– Maximum contribution a year is 18 per cent of earned income or $22,970.
– Unused contribution room can accumulate.
– RRSPs must be converted to a registered retirement income fund or life annuity by 71.
– Can affect government benefits such as Old Age Security.
– Upon your death, your RRSP can be rolled over tax-free to your spouse. However, when he or she dies, what’s left will be taxed before going to your children or heirs.
– May be a better option for high-income earners
– Contributions are not tax deductible.
– Withdrawals are not taxed as earned income.
– Maximum contribution a year is $5,500 a year no matter what your income is.
– Unused contribution room can accumulate.
– TFSAs do not have to be converted into another investment form at any age.
– Won’t affect other government benefits such as Old Age Security.
– The TFSA rolls over tax-free to your spouse upon your death. When he or she dies, only the increase in the value of the TFSA since the date of death is taxed in the year the heirs inherit it.
– Likely the best choice for lower-income earners