The Wealthy Barber explains: TFSA or RRSP?
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.
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 Down the road, however, when money is withdrawn directly from the RRSP or from the registered retirement income fund (RRIF) or annuity to which the RRSP has been converted, it will be taxable.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:
TFSAversus RRSPPre-tax Income$1,000$1,000Tax$ 400N/ANet contribution$ 600$1,000Value 20 years later @ 6% growth$1,924$3,207Tax upon withdrawal (40%*)N/A$1,283Net 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.
Let’s look at a new chart that reflects that reality:
TFSAversus RRSPContributed after-tax savings$1,000$1,000Value 20 years later @ 6% growth$3,207$3,207Tax upon withdrawal (40%)N/A$1,283Net 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.
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!