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

Let’s look at a new chart that reflects that reality:

TFSA

versus RRSP

Contributed after-tax savings

$1,000

$1,000

Value 20 years later @ 6% growth

$3,207

$3,207

Tax upon withdrawal (40%)

N/A

$1,283

Net withdrawal

$3,207

$1,924

Holy smokes, the TFSA is kickin’ butt!

“That’s not fair,” you might argue. “You forgot to include the $400 tax refund that the RRSP contribution generates!”

No, I didn’t. It’s a chair now. Or half an iPad. Or a flight to Vegas.

And that’s fine. I’m not saying it was squandered – chairs are important, especially when you’re sitting. But it does mean the $400 won’t help your retirement and, therefore, in this scenario, from a financial-planning perspective, the TFSA is a clear winner.

Even when we assume you’ll follow the first chart’s lead and contribute to an RRSP the pre-tax equivalent of the TFSA contribution ($1,000 to $600), the comparison is still trickier than it first seemed.

Why?

When you withdraw money from your RRSP or RRIF (or receive an income from an annuity to which your RRSP was converted), not only do you have to pay taxes on it, but your increased income could also lead to higher clawbacks of your Old Age Security pension, Guaranteed Income Supplement and other means-tested government benefits.

Yikes, the math here is more complex than the RRSP versus RESP debate. Way more. I don’t even drink and I want a beer.

And talk about assumptions! Oh my. Go ahead: Take your best guess at what your taxable income will be 10, 20 and 30 years down the road. What about future tax rates? Will clawback rules be altered? In retirement, will you be able to income split with your spouse or will your spouse already have split with some of your income?

Wow. Maybe I should make that beer a scotch.

I’ve checked out a dozen analyses on the Internet and all that did was reinforce how challenging this comparison is. For example, very few factored in the effect an RRSP contribution can make on the amount of the Canada Child Tax Benefit (CCTB) parents receive. Also, almost all of the researchers assumed every dollar withdrawn from an RRSP or RRIF will be taxed at the marginal tax rate. Think about that – it’s not always the case. If I have $10,000 in government-pension income and receive a RRIF payment of $53,000, it’s not all going to be taxed at the marginal rate. In some cases, it would be more appropriate to use the average rate of tax on the withdrawal in the calculations.

That’s not nitpicky – points like the last one can’t be ignored. They’re vital parts of the evaluation. Unfortunately.

Wake up! I’m almost done.

Based on the various assumption sets I used, the TFSA won a surprising percentage of the time (though usually not by a wide margin). In fact, for most low-income earners, it was the victor under the majority of scenarios.

That said, I frankly have no idea which way you should go. At the risk of being branded The Wishy-Washy Barber, I think it would be irresponsible to give a definitive “do this.” Sit down with your advisor – he or she will at least have the advantage of being able to customize the assumptions to your situation. Plus, I’m sure there will soon be software or an app developed to help you figure this out. Try to curb your enthusiasm.

My final thought here is important (no, really!). TFSAs are very flexible. You can take money out of one at any time and then put it back in future years. That’s being trumpeted as a huge positive by many financial writers, but it scares the heck out of me.

I’m worried that many Canadians who are using TFSAs as retirement-savings vehicles are going to have trouble avoiding the temptation to raid their plans. Many will rationalize, “I’ll just dip in now to help pay for our trip, but I’ll replace it next year.” Will they? It’s tough enough to save the new contributions each year. Also setting aside the replacement money? Colour me skeptical. The reason I always sound so distrustful of people’s fiscal discipline is that after decades of studying financial plans, I am always distrustful of people’s fiscal discipline. And even if I’m proven wrong and the money is recontributed, what about the sacrificed growth while the money was out of the TFSA? Gone forever.

Reminders: (1) If you go the RRSP route, don’t spend your refund; (2) If you go the TFSA route, don’t spend your TFSA; (3) Whatever route you go, save more!

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