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Love the tax refund you get when you make an RRSP contribution? Too bad it doesn't love you back.

"People are so fixated on the windfall of the refund that they don't really understand the mechanics," says Jamie Golombek, managing director of tax and estate planning with CIBC Private Wealth Management.

If you master the mechanics, Mr. Golombek argues in a paper to be released Thursday, you have a strong argument for considering tax-free savings accounts over registered retirement savings plans as a way to put money away for the years after you quit working. Of course, this assumes you don't have the bucks to max out both RRSPs and TFSAs.

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Young adults just entering the workforce and middle-income earners are particular candidates for using TFSAs, which were introduced two years ago and allow people aged 18 and older to invest or save up to $5,000 a year and pay no tax on their gains.

TFSAs are an all-purpose savings vehicle, in large part because you can take money out and then put it back again in a later calendar year. The conventional view is that RRSPs are just for retirement, but Mr. Golombek's take is that people view them more as a mechanism for reducing income taxes in the here and now (note: there's no tax break on TFSA contributions).

He argues that the refund resulting from an RRSP contribution is money you have to repay later on in retirement when you generate taxable income by making a withdrawal from your plan. You avoid tax today, but pay it decades in the future.

"That's why I called my report Blinded By The Refund," Mr. Golombek said. "It [the refund] is not a windfall, it's a deferral of tax."

Exactly how much tax you pay on an RRSP withdrawal in retirement depends on your tax rate at the time. Conventional thinking is that your tax rate will be lower than it is when working, but Mr. Golombek said this won't be the case for many people whose RRSP withdrawals bump up their income enough to trigger a clawback of federal government benefits for seniors.

Let's say your marginal tax rate is 35 per cent today and 30 per cent in retirement. Mr. Golombek said that a clawback of your Old Age Security payments alone would have the same impact as adding an additional 10 percentage points or so to your tax rate. Effectively, then, your marginal tax rate could theoretically jump to 40 per cent in retirement from 35 per cent in your working years.

OAS payments start to be clawed back when your annual retirement income reaches about $67,000 in today's dollars, Mr. Golombek said. One way to stay below this threshold is to use TFSAs for retirement saving.

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Money withdrawn from a TFSA is tax-free, so it won't layer on top of your other sources of retirement saving and bump up your income to a level where the OAS clawback is a factor. RRSP withdrawals represent taxable income, so they have just the opposite effect.

Mr. Golombek said it's widely thought that people with incomes of less than $40,000 while working shouldn't contribute to RRSPs because of the risk they could trigger a clawback of OAS and other government benefits for seniors. TFSAs are the natural alternative.

What do low-salaried young adults who are starting out in the workforce care about clawbacks in their senior years? Not much. But they can still benefit from using TFSAs to save for retirement.

Someone who lands a first job with a salary of $40,000 would be at a low marginal tax rate and thus qualify for only a comparatively modest tax refund for an RRSP contribution.

Flash ahead to retirement and it's not a stretch to see this person in a much higher tax bracket. Thus the tax hit on an RRSP withdrawal could be larger than the refund generated when the money was first contributed to the plan. As well, the RRSP withdrawal could end up causing a clawback of government benefits.

Mr. Golombek said there's a case for putting RRSPs ahead of TFSAs for high-income earners who expect a six-figure annual retirement income. These people benefit in a big way from the tax-reduction of making RRSP contributions and, with annual income in excess of $110,000 or so in today's dollars, they can expect all their OAS to be clawed back.

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TFSAs are a good retirement savings option for lots of people, but Mr. Golombek rejects any blanket dismissals of RRSPs. "The message I don't want to get out there is that RRSPs are bad, because they're not."

TFSAs v. RRSPs for retirement saving

Dick and Jane both make $60,000 per year and both need an after-tax income of just over $44,000. Here's how Dick gets there by generating a tax refund with a $5,000 RRSP contribution and Jane gets there simply by putting $3,442 in a TFSA. Note that tax will have to be paid on the RRSP contribution when it's withdrawn from the plan in retirement, whereas no tax will apply to a TFSA withdrawal.






RRSP contribution



Taxable income



TFSA contribution



Net cash, pre-tax



Total federal, Ontario tax *



Net cash to spend



* Assumes 2010 federal and Ontario tax rates, considers only the basic personal credit and ignores Ontario Health Premium. Source: Jamie Golombek, CIBC Private Wealth Management

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