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Book Excerpt

The Wealthy Barber explains: TFSA or RRSP? Add to ...

This is an excerpt from The Wealthy Barber Returns: Significantly Older and Marginally Wiser, Dave Chilton Offers His Unique Perspectives on the World of Money By David Chilton. Copyright © 2011 by David Barr Chilton, released September 2011.

Battle of the Abbreviations

Remember when life was simple? You needed to save and invest for retirement, so you opened an RRSP and contributed as much as you could each year.

Sure, the saving part was tough. And, of course, investing always had its challenges. But at least we all knew that an RRSP was the way to go.

Everybody said so. The woman on TV. Your advisor. The Wealthy Barber guy. Even your know-nothin’ cousin.

Then in 2009, along came the TFSA – totally fantastic savings account (or tax-free savings account).

Hmm. Suddenly, a second option to house our retirement dollars. What to do?

Many counsel us to put the maximum allowable amount into both our RRSPs and our TFSAs. For big-income, childless people living rent-free in their parents’ basements, that’s unquestionably solid advice.

The rest of us are probably going to have to prioritize. We need to figure out which vehicle to focus on first.

When you make an RRSP contribution, you get to deduct that amount from your taxable income. The investments inside your RRSP grow free of tax while they stay in the plan. Down the road, however, when money is withdrawn directly from the RRSP or from the registered retirement income fund (RRIF) or annuity to which the RRSP has been converted, it will be taxable.

I’m alarmed by how many Canadians still don’t fully grasp that last point. Over and over again, I see net-worth statements where the full value of an individual’s RRSP is listed on the Assets side, but no corresponding eventual-tax-owing amount is recorded on the Liabilities side.

You may have a $110,000 RRSP but you also have a partner – the government – waiting patiently for its share. Annoying, but true.

In essence, a TFSA is the mirror image of an RRSP. You contribute after-tax dollars. In other words, you don’t get a deduction for your contribution. But once the money is in the plan, it not only grows free of tax, but also comes out free of tax. No tax ever! Fantastico!

If you don’t love TFSAs, sorry, you’re nuts. But that doesn’t necessarily mean you should love them more than RRSPs.

When the federal government introduced TFSAs, it created a chart similar to this one:

TFSA

versus RRSP

Pre-tax Income

$1,000

$1,000

Tax

$ 400

N/A

Net contribution

$ 600

$1,000

Value 20 years later @ 6% growth

$1,924

$3,207

Tax upon withdrawal (40%*)

N/A

$1,283

Net withdrawal

$1,924

$1,924

* the marginal tax rate — the rate of tax charged on the last dollar of income

I’ve spent almost two full books trying to avoid number-laden charts, but this simple, little table is quite illuminating. It neatly shows how a TFSA contribution is made with after-tax dollars, while withdrawals are tax-free. And an RRSP contribution is made with pre-tax dollars, while withdrawals are taxable. Yes, I’ve already explained that, but I thought it best to repeat.

The chart also demonstrates that if your marginal tax rate at the time of the RRSP contribution is the same as at the time of the withdrawal, TFSAs and RRSPs work out equally well.

Even the numerically challenged can understand that if the marginal tax rate is lower at the time of withdrawal than at the time of contribution, the RRSP will win. Conversely, if the marginal tax rate is higher at the time of withdrawal than at the time of contribution, the TFSA will win.

Easy, right? You just need to guess your marginal tax rate at the time of potential withdrawal and base your decision on that.

I’m so disappointed that it’s not that simple, darn it. I love simple. But sadly, the real world is more complicated than the chart world. Quite a bit more complicated.

In the last chapter, we saw that many of us, if not most of us, contribute to RRSPs with after-tax savings and then spend the refund. I hope the previous chapter changes that, but for right now, that’s the way it is. Heck, having some fun with our refund cheque is like playing this year’s first golf game or gardening on May 24th – it’s an annual Canadian tradition. A rite of spring.

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