Many Canadians would get more bang for their buck by taking a pass on the registered retirement savings plan and plowing any future savings into a tax-free savings account, says a new report.
A C.D. Howe Institute e-brief released Wednesday, in the thick of RRSP season, is challenging the notion that saving for retirement is best done through a tax-deferred plan like the RRSP.
"While not actively marketed as a primary retirement saving tool, TFSAs represent, for many taxpayers, a more tax-efficient retirement savings vehicle than traditional tax-deferred accounts," wrote Alexandre Laurin and Finn Poschmann, who co-authored the report for the think tank.
"Why? Because the effective rate of tax payable on retirement income is often higher than that imposed on regular income during working life."
While not actively marketed as a primary retirement saving tool, TFSAs represent, for many taxpayers, a more tax-efficient retirement savings vehicle than traditional tax-deferred accounts. C.D. Howe report
In the report, the two men compared the estimated impact of different tax structures to determine which plan provided people with the greatest advantages. Comparing marginal effective tax rates during various stages of people's lives, they found that Canadians with savings in pension plans and RRSPs would do well to stream further savings into TFSAs. They define marginal effective tax rates as the effective tax burden on the last dollar of income saved or withdrawn.
"The majority of Canadians who can reasonably predict their taxable incomes post-retirement will probably find that their marginal effective tax rate on retirement income will be higher than on their work income; not lower as is often assumed," they said.
Mr. Poschmann has been a long-standing supporter of the TFSA. Back in 2001, he and Jon Kesselman wrote a report that advocated the creation of a tax-free savings vehicle similar to the TFSA.
But York University professor Moshe Milevsky believes telling people to contribute to a TFSA and not to a RESP is "a bit simplistic at this time," given that contributions to a TFSA currently top out at $10,000 while many people likely have twenty times that in unused RRSP room.
"Ten years from now, if the government does not change the restrictions on the TSFA and suddenly we have room for $50,000, then suddenly it becomes very interesting," he said in an interview. "Then you can have the debate of do you put it in a TFSA or an RRSP?"
The TFSA, unveiled by Finance Minister Jim Flaherty in the 2008 budget, has proven to be vastly popular with Canadians. Studies have shown that people are using the new vehicle for everything from an emergency fund to boosting their retirement savings.
With the March 1 RRSP deadline around the corner, Canadians who don't have enough money for both will be forced to choose between the two options and are likely struggling with the dilemma of how best to save for their golden years.
Whether you end up choosing the TSFA or an RRSP depends on your tax rate, both now and when you have retired and are withdrawing your money, the C.D. Howe report says. For people at the beginning of their working life, that can be a difficult thing to predict. But those nearing retirement age should be able to make an educated guess.
Investor Education: TFSAs
Using analysis that applies to marginal tax rates only, Mr. Laurin and Mr. Poschmann found that while most Canadians expect higher tax rates when they are working, as opposed to retired, many will actually have a higher marginal effective tax rate on their income from retirement savings.
"People further away from retirement must inevitably deal with greater uncertainty about earnings, investment returns, and future tax changes..," the report said. "For all Canadians, however, the contrast between marginal effective tax rates in working life and in retirement is a vital consideration in choosing how to save."
Professor Milevsky says that instead of asking whether they should save for retirement in a TSFA or an RRSP, people should ask whether they will be in a higher or lower tax rate once they stop working.
"It really depends on what your income tax rate is going to be in retirement versus what it is now. For someone whose tax rate is the same in retirement as when they are working, it does not matter whether you put it in an TFSA or an RRSP," he said.
Ultimately, people would do well to put money in both a TFSA and an RRSP, Professor Milevsky said. "That way you can control what pile of money you can pull money out of, depending on how each year in retirement pans out. So during a retirement year when your investments don't do well, you would pull money out of an RRSP. If the next year they fare well, you could get money out of your TFSA."
In terms of the policy implications of a shift to retirement savings in a TSFA as opposed to an RRSP, the C.D. Howe report says governments looking to strengthen incentives for private retirement savings should think of further opportunities to save on a tax-prepaid basis. "One option would be to allow taxpayers more freedom in allocating saving room between RRSP/RSP accounts and TFSAs, and more room for saving in TFSAs."
Governments should adjust their long-term fiscal plans "to reflect the fact that the tax base will continue to shift away from income, and toward consumption, which will affect the timing of tax revenue."