This is a question that I get very frequently, especially around RRSP and Tax season. I am still amazed at how little knowledge there is about this program and the associated rules. Before getting into the answer to the philosophical question as to whether a TFSA or an RRSP makes sense, it would be prudent to re-visit the definition of a TFSA.
From the CRA Website: (http://www.tfsa.gc.ca/)
"A TFSA is a Tax Free Savings Account that is a flexible, registered, general-purpose savings vehicle that allows Canadians to earn tax-free investment income to more easily meet lifetime savings needs. The TFSA complements existing registered savings plans like the Registered Retirement Savings Plans (RRSP) and the Registered Education Savings Plans (RESP). "
No wonder there is confusion around this. Put a little more simply, a TFSA is an investment vehicle that allows both tax sheltered growth of your money, as well as tax free income at withdrawal. Unlike what the name indicates, a TFSA does not have to be allocated to a savings account. In fact, in today's low interest rate environment, it would make sense not to invest in a savings account. I provide an example of this at the end of the article (example 1)
Another little known fact is that when a withdrawal is made from a TFSA, it creates the opportunity to return this money back to the TFSA in the subsequent year.
To date, we have a lifetime contribution amount of TFSA capital deposits of $36,500. This is calculated as $5,000 contribution room from 2009-2012 and then an increase from 2013-2015 to $5,500.
If you had contributed the maximum contribution from inception and between capital contributions and growth, the account was valued at $42,000, you could withdraw all $42,000 and replace that amount the following year, along with the room that had been created for that year as well. (Example 2)
A Third unique difference between a TFSA and an RRSP is that there is no taxable deduction for a contribution to a TFSA, unlike the RRSP which does allow you to proportionally off-set the RRSP deposit from your income. The theory behind the RRSP and the deduction is that hypothetically one would be in a higher tax bracket while working, and would be able to deduct more from ones income, potentially allowing the individual to move into a different and lower tax bracket. When income is taken in the latter years the premise is that the income of the individual will be lower and, therefore, more beneficial from a tax perspective.
With all of the above in mind, does it make more sense to contribute to an RRSP then it does to a TFSA?
The answer is that it depends on your tax situation. I suggest to my clients that within the first 60 days after the end of the previous calendar year, they do a mock up on their taxes. Assuming that the result indicates that either no tax would be owing, or better yet, that they would be eligible for a refund, I recommend no RRSP deposit be made. An RRSP contribution as in my example would further enhance a refund, meaning that you have paid too much tax in a given year, and will have that over-payment refunded.
Building up the value of the TFSA will allow for the opportunity to blend taxable and non-taxable income in the future. This will help to keep the overall tax rate down for an individual, but just as important, means that a lower gross withdrawal is required to provide the same net income. (Example 3)
One final consideration is Old Age Security (OAS) and the associated clawback. If there is too much taxable income being taken then it is possible the government could start clawing back some of the OAS. Income from a TFSA has no impact on income thresholds for OAS clawback purposes.
In summary, most people have been programmed to contribute to an RRSP because that was really the only tax sheltered accrual vehicle available. Now with the TFSA, you have options. Granted when you contribute to a TFSA, you won't get a juicy refund cheque for
RRSP contributions, but conversely you won't have the potential taxable income issues that you could in retirement if the TFSA is not incorporated as part of your overall planning.
If you were able to get a 2% interest rate for your savings account (highly unlikely in today's environment) and you had accrued $25,000 invested in your TFSA, you would in fact be able to protect the interest, ($500 in this case), that would otherwise have to be claimed for that corresponding tax year. In a 50% tax bracket, you would save $250 of taxable income.
It's hardly worth sheltering that small amount of money. On the flip side, if you had invested in a basket of US equities last year, it would not be out of the realm of possibility to earn a 20% return on this money. This would equate to a $5,000 savings on taxable income amounting to a tax savings of $1,250 or more depending on the treatment of income. The perception that the money has to be allocated to a "savings account" is not only a misconception, but it could be preventing you from maximizing the tax benefit of the Tax Free Savings Account.
If we assume contribution rates remain at $5,500 going forward, you could deposit the $47,500 ($42,000 plus $5,500) and calculate it as the replacement of the capital and growth withdrawn in 2015. Conversely, an RRSP withdrawal is not only taxable, but you never get the RRSP room back once it is withdrawn. This is a significant difference between the TFSA and the RRSP.
To better illustrate this point, if $36,000 net of income is needed over and above the CPP and OAS, then it would require a gross amount of $45,000 be withdrawn from an RRSP/RRIF to net $36,000. In contrast, it would require $36,000 withdrawn from a TFSA to provide the same amount of income. This would preserve an additional $9,000 of capital that would otherwise have to be taken.
Brad Amlin, CFP
Financial Advisor with Cornwall Wealth Management (formerly Marlatt Limited)