When the government introduced tax-free savings accounts with its 2008 budget, it billed them as "the single most important personal savings vehicle since the introduction of the registered retirement savings plan."
Now in its third year, the little brother of the RRSP is proving to be more than just a super-powered savings account. For many Canadians, the TFSA has become preferred over the venerable RRSP to save for retirement.
Created to be a complementary tool, the TFSA is steadily winning converts in part because it is far less complicated. Because money stashed in a TFSA is already taxed, people can dip into their tax-proof account whenever they want, without future tax consequences.
Compare that to RRSPs, where any money withdrawn is treated as regular income and will ultimately increase a person's year-end tax bill and could result in the clawback of income from government programs. The TFSA also represents a smaller chunk of change - $5,000 compared with 18 per cent of earned income to a maximum of $22,000 for 2010.
So who should find the TFSA's allure irresistible? Those just starting out in their careers, people with rock-solid pensions, and anyone with a little cash to set aside during the year.
"I just finished my first financial plan where I do not recommend my clients contribute to RRSPs," said Frank Wiginton, a certified financial planner with TriDelta Financial of Toronto. His clients are not, as one might expect, gearing down for retirement and worried about how their well-stuffed RRSPs will fare before the taxman. Instead, they are in their mid-30s and pulling in a combined income of about $120,000 annually.
So why no RRSP savings for the next three decades of their working lives?
"They have defined-benefit pensions, they both work for government agencies," explained Mr. Wiginton. The couple, who already have some money put away in their registered plans, also have a rental property and, by the planner's calculations, they will end up paying more in taxes in retirement than they pay now, which makes RRSPs a future burden instead of a benefit.
"They are being taxed now at an average of 22 or 23 per cent based on their incomes, but in retirement their average tax rate is going to jump up to 28 per cent" even without further RRSP savings, he said. "Their plan was to contribute $3,000 or $4,000 a year to RRSPs - their pensions limit how much they can contribute - but my recommendation was 'No, don't.'"
Only a minority of Canadians have the income, budgeting skills or frugality that is necessary to maximize both their RRSP and TFSA every year. That means for most, there should be some thinking as to how much money should go into the respective tax shelters.
Kim Petch, who lives in Windsor, Ont., and writes about financial matters on her Balance Junkie blog, said that she and her husband have created a hierarchy of mortgage, TFSA and, finally, RRSPs. "Given our age and our current retirement savings, we will need to save more than our TFSA limit each year, so we don't think we can go wrong by topping up the TFSAs first," she said. With any excess money devoted to their mortgage, the couple's TFSAs "are only about half full based on our 2011 limits," but provide them with a valuable cushion. "We are keeping the TFSA money as an emergency fund, although we have considered emptying them to wipe out the mortgage."
Janice Vervaeke, a manager with the Ontario government, has maximized her TFSA contribution since it was introduced at the start of 2009 and curtailed any further contributions to her RRSP. "My pension is going to be such that if I have RRSPs I am going to pay a lot of tax on them," she said. "I also just liked the ability to get to my money sooner if I need to."
Ms. Vervaeke, who lives in Peterborough, Ont., is eligible for early retirement in six years and is adamant that she will leave her job when the date arrives. "Oh yeah, I'm positioning myself and I'm working to get debt free."
Ms. Vervaeke's financial adviser, Oakville, Ont.-based planner Brian Poncelet, is finding that he is recommending the TFSA over RRSPs more with his clients. "With RRSPs you are just deferring the taxes until later and whatever money you make you are a partner with the CRA (Canada Revenue Agency). If you had only one choice and five grand, I would say put it in a tax-free savings account."
Financial planners say that TFSAs make a great amount of sense for young workers who are not pulling in a big salary and consequently do not reap the same tax deductions as those who are in their prime earning years and find themselves in the highest tax brackets. Mr. Wiginton estimates that for workers in the lowest tax rungs, the tax break on RRSPs can be as low as 15 cents on the dollar compared with 38 cents paid back in tax refunds for every dollar contributed to a registered plan for those in the highest tax bracket.
Small and nimble and easy to use as it is, however, its simplicity can also act against its holders, Mr. Wiginton observed. "A lot of people look at it and say 'Ah, it's just $5,000. A buddy of mine, he's 52 and he's a cop who can retire at 55 with $10,000 and he says he wants to pull that out next year to fix his boat." He would like the government to add the word "retirement" to TFSAs like it did from the start with the RRSP. "Most people just don't grasp the concept of the TFSA and how it can be used most effectively."
In making the TFSA-RRSP calculation, Canadians also need to estimate - in many cases guess - what their retirement finances are going to look like. "At this point people have to kind of pull out a crystal ball and decide what is going to be the hardest (tax) hit - upfront, or later one," said Kerry Taylor, who blogs about personal finance on the Squawkfox website. The Vancouver-based 37-year-old finds herself constantly urging those in their 20s to set up a TFSA. "If you are young and you are in a low tax bracket, the RRSP is going to be your biggest hindrance when you retire. You are going to have low income when you are young and low income when you are retired.'
Ms. Taylor, a self-described "super saver" who fills her blog with money saving tips, doesn't think much about the TFSA-RRSP debate when it comes to her own finances, however. "Last year I maxed both, I am in such a habit where I just max everything out."
Most of us could do the same, if we were just willing to take on her lifestyle.
"I have no cable, I don't have a really expensive car, I have no debt. Everything I earn I basically save," she says. Ms. Taylor recognizes that she represents a small minority and is sympathetic to those who are no position to adopt her uber frugal mentality. "Most Canadians can't. They are paying their mortgage, they are feeding their kids. It's hard."
Two scenarios
For some people, the choice between a tax free savings account and an RRSP is obvious. For others, not so much. David Christianson, a financial planner and portfolio manager with Wellington West Total Wealth Management Inc. in Winnipeg, cited this scenario:
An individual has $5,000. She also has a 35 per cent marginal tax rate today, and a 28 per cent rate in retirement.
That $5,000 RRSP contribution and tax deduction saves $1,750 in immediate taxes. Add these two amounts and $6,750 can go into the RRSP this year, compared with $5,000 into the TFSA.
Do that for 30 years earning 7 per cent on average, and the TFSA grows to about $434,000, while the RRSP is worth about $586,000. Advantage RRSP.
"But here is where it gets fun," noted Mr. Christianson. Assuming annual withdrawals of 5 per cent in retirement, the TFSA produces $21,700, compared with $29,300 from the RRSP. The $21,700 is income-tax free. The RRSP income is taxed at 28 per cent, which means an $8,204 hit, leaving $21,096 to spend. Advantage TFSA.
Another consideration is that the RRSP income can cause the loss or reduction of income-tested tax credits or other programs, such as the Age Credit and Medical Expense Credit, which means an effective 25 per cent additional penalty. To the extent that your income is above $66,733 after age 65, then you will also lose $3 of Old Age Security for each $1 of taxable income.
Because each investor's situation is unique, a tax professional should be consulted.