My Own Advisor

There is no shortage of blogposts and media articles about which account is better for retirement purposes:  the Registered Retirement Savings Plan (RRSP) or the Tax Free Savings Account (TFSA).  I’ve got my preference for which account I focus on for retirement purposes but let’s recap some key points about each plan first:

RRSP	TFSA
A tax-deferral plan.	A tax-free plan.
Contributions can be made with “before-tax” dollars as part of an employer-sponsored plan or “after-tax” dollars when a contribution is made with a financial institution.	Contributions are made with “after-tax” dollars.
Contributions are tax deductible; you will get a refund roughly equal to the amount of multiplying your contribution by your tax rate.	Contributions are not tax deductible; there is no refund to be had.
If you don’t contribute your maximum allowable amount in any given year you can carry forward contribution room, up to your limit.
If you make a withdrawal, contribution room is lost.	If you make a withdrawal, amounts withdrawn create an equal amount of contribution room you can re-contribute the following year.
Because contributions weren’t taxed when they were made (you got a refund), contributions and investment earnings inside the plan are taxable upon withdrawal.  They are treated as income and taxed at your current tax rate.	Because contributions were taxed (there was no refund), contributions and investing earnings inside the account are tax exempt upon withdrawal.
Since withdrawals are treated as income, withdrawals could reduce retirement government benefits.	Withdrawals are not considered taxable income.  So, government income-tested benefits and tax credits such as the GST Credit, Old Age Security (OAS) and the Guaranteed Income Supplement (GIS) aren’t affected by withdrawals.
You can’t contribute to an RRSP after age of 71. Accounts must be collapsed in the 71st year.	You can contribute to a TFSA after age of 71.
The Summary:  part of your RRSP is borrowed money.	The Summary:  all of your TFSA is your money.

Based on my personal investment plan, I feel the TFSA ultimately trumps the RRSP as a retirement vehicle even though I contribute to both every year.   All the money in the TFSA is mine to keep, grow and manage with no tax consequences.  The RRSP refund is great but it’s actually temporary; you need to give it back at some point.  This makes reinvesting the RRSP refund year after year absolutely critical in my opinion to optimize wealth building – to take major advantage of an essentially long-term but not permanent government loan.

That said about this loan I firmly believe using the RRSP will work out very well for the majority of Canadians, hopefully myself included!  It totally makes sense when your marginal tax rate at the time of contribution is greater than your marginal tax rate at the time of withdrawal.  Jim Yih has written about this point numerous times in many of his great blogposts.  Check out his articles here and here.

If this tax situation applies to you this RRSP season then by all means use the RRSP as much as you can to defer tax now, grow your portfolio and get your refund back to reinvest money back into your RRSP.  If however for whatever reason, you need to use the RRSP refund for other things this spring (like a vacation?) that’s fine.  As part of this tax season just be mindful of the potential consequences of not managing the refund well this and every “RRSP season”.

Are you contributing to your RRSP this year?  If so, what is your strategy?  To max-out the contribution and reinvest the refund?

Thanks for reading and sharing this article.

 

Over the last week or so, a few articles discussing the merits of contributing to the Tax Free Savings Account (TFSA) over the Registered Retirement Savings Plan (RRSP) and other RRSP contribution posts, really caught my eye.

The first one was on Passive Income Earner, where he discussed how to maximize your RRSP.

RRSPs are an excellent savings tool no doubt.  I have one myself and I contribute to it every month.  I’ve been contributing to my RRSP for over 10 years since my mid-20s.  

RRSPs are excellent because the contribution you make lowers your taxable income – and you may get a tax refund because of it – pretty nice formula.  The problem some Canadians might have in using the RRSP is what they do with the tax refund from the contribution.  If you consider this tax refund a “gift”, that is, you are going to spend it all then you’re not really harnessing the power of the RRSP.  Let’s dive deeper and revisit two key advantages of RRSPs:

1. The tax deduction, and
2. The tax-deferred growth.

Tax deduction

Consider working in the 40% tax bracket: 

• If you put $300 per month into the RRSP for the year, that’s a nice $3,600 contribution.
• You’ll get a $1,440 refund (40% of $3,600).

When your $1,440 cheque arrives, you decide to spend it on a trip to Cuba to escape our long, cold-winter.  Sounds like fun…I’d love to do that too!  When you do that however, just know this $1,440 refund is effectively borrowed money – a long-term loan from the government they are going to come back for, in whole or in part (more on that in a bit).   If you always spend your refund you are undermining the effectiveness of RRSPs because you are giving up your loan.  A refund associated with your RRSP contribution should not be considered a financial windfall but present value of a future tax payment you must make.    

To really harness the power of your diligent RRSP contributions make some decisions about what you’re going to do with the RRSP refund first – ensuring you put the money to work.  Consider the following as a few options:   

• Reinvest it back into your RRSP (great bang for your buck).
• Pay down your mortgage (a guaranteed rate of return on debt + interest).
• Contribute the refund to your TFSA or another registered savings vehicle (reinvested money for growth).

If you typically spend the $1,440 “gift” in my example then I think you’re better off prioritizing your TFSA over your RRSP because of the known benefits of that present day contribution.  

Tax deferred-growth

At some point, the money that comes out of your RRSP will be taxed.   The tax man will find you and he will ask for his refund.  In my example, that’s your $1,440 if your marginal tax rate in retirement is the same as your working years today.  It could be lower but with your Canada Pension Plan (CPP), Old Age Security (OAS), pension income and other investments, it could be higher. 

With TFSAs, the government has eliminated the guesswork about how much the payback will be for the loaned money – because you don’t get any.  You don’t get any tax break on the TFSA contribution so the government is nice enough to offer tax free withdrawals coming out.  Even though TFSAs have largely been marketed as a “savings account”, you can open TFSAs that hold stocks, bonds and ETFs.  I know, because that’s my account.  You might know many of the TFSA benefits already.  If you don’t, the other great article I read recently on Dividend Ninja will tell you all about it. 

Personally, I have no idea of what my tax rate will be 20 years from now.  I can guess but that’s about it.  I have a pension and other investments.  I’ll calculate all this out in a few decades when I’m a few years away from retirement age and ready to start accepting some  income from government programs…if they still exist!  If you know for sure your tax rate will be significantly lower in retirement than today, RRSP contributions are a wise thing to do.  If not, making the TFSA a higher priority might be a better choice.  Contributing to the TFSA today removes any guesswork about future marginal tax rates or any other federally income-tested programs down the road. 

TFSAs – Withdrawals are not considered taxable income.  Income-tested benefits and income tax credits such as the GST Credit, Old Age Security (OAS) and the Guaranteed Income Supplement (GIS) aren’t affected by any TFSA withdrawals.  Withdrawals don’t reduce these benefits.

RRSPs – Withdrawals are considered taxable income.  RRSP withdrawals could reduce amounts you receive from income-tested benefits and income tax credits such as the GST Credit, OAS and GIS.  RRSP withdrawals could reduce your post-retirement government benefits.

I’m not suggesting to use one account exclusively over the other.  Both accounts have great merits so you use both if you can!  I contribute to both my RRSP and TFSA every year but the TFSA takes priority.  You can read another post about that:   I’ll maximize my TFSA first.

Based on my current situation, I’ll try and maximize my TFSA contributions long before I try to do the same for my RRSP.   If you don’t invest the same that’s OK because your financial situation might be different.  If you haven’t done some math on the TFSA vs. RRSP debate, I encourage you to check out this tool courtesy of Retirement Advisor and run some of the TFSA vs. RRSP math for yourself.   You might be surprised by the results.

Amidst RRSP campaigns this winter, take some time to look at your financial situation and try and figure out what works best for you.   Remember, nobody cares more about your financial future than you.

Thanks for reading and sharing this article.

A fews weeks ago I returned home from a golf vacation, a “boys vacation” in Myrtle Beach, South Carolina.  The vacation was great; great friends, great accommodations, great fun even if the golf game was lacklustre.  Ottawa to Myrtle Beach (and back again) is a long drive, about 30 hours in total, 15 hours each way.  As you can probably imagine, with that much time to kill amongst a few grown men away from their wives for a few days, a host of interesting and surprising topics come up.  Some topics are quite tame with the usual needling that occurs amongst men and other topics, well, not so much.  I can’t repeat some of those topics shared during our long drive on this blog because they would be x-rated   One of the topics that arose during our long drive to and from our fun in the sun was investing, specifically, TFSAs or RRSPs, which is the better investment choice?

I know you’ve heard the debate before:  TFSAs are better than RRSPs, RRSPs are better than TFSAs.  Today’s post is about my preference:  maximizing my TFSA before maximizing my RRSP, and why.

First of all, I’m a huge believer in savings.  Why?  Because you don’t have any shot at a comfortable tomorrow if you don’t start saving for it today.   In this regard, I think both investment choices work quite nicely; TFSAs and RRSPs are excellent vehicles to put some money somewhere in something that should grow over time, and you’ll see the wisdom of this as you complete your income tax software each year.  Anything is better than a bank account earning low interest.  However, I believe all investment choices should consider tax attributes or tax implications.  I say this because there is no value saving like a mad-man when tax characteristics could compromise those savings.

So, let’s look at a few tax characteristics of the TFSA as I understand them:

TFSA

• Any income or gains earned in your TFSA (from interest, dividends or capital gains) are tax-free as the name of the account suggests.
• Any withdrawals from your TFSA are not taxable to you.  If you make a withdrawal from your TFSA that amount will be added to the following year’s contribution room.  You don’t even have to report withdrawals on your tax return.
• You do not receive any tax-deduction from a TFSA contribution; TFSA contributions are made with after-tax dollars.
• As soon as you’re 18 years of age or older, you can have a TFSA.  There is no age maximum for this account – you can contribute to a TFSA until life’s bitter end.
• TFSA withdrawals are not counted as income (my favourite).

Overall, pretty amazing stuff folks and those are just the highlights.

Let’s take a look at a few tax characteristics of RRSPs as I understand them:

RRSP

• Any income or gains earned inside your RRSP are tax-free until withdrawn.
• Contributions to your RRSP are not counted as income; RRSP contributions receive a deduction based on your marginal tax rate.
• Withdrawals from an RRSP are taxable to you.  They will be taxed as regular income regardless of source (from interest, dividends or capital gains) at your marginal tax rate.
• You must convert your RRSP to a RRIF (then start withdrawing), buy an annuity or cash out this account in the year you turn 71.  There is an age maximum on this account.

Still very impressive stuff.

Which one do I prefer and why?

Since I believe in my investment vehicles taking both growth potential and long-term tax implications into consideration, I prefer to maximize my TFSA over my RRSP every time.

I’ll qualify this statement by saying the biggest advantage of RRSPs over
TFSAs is the tax-deductible contribution you get today and the power it can
provide if tax refunds are reinvested going-forward.  Simply put, RRSPs are an amazing tax-deferral tool.  If you intend to save for a long period of time (e.g., for retirement over 20+ years) and reinvest your tax refund every year then RRSPs have an advantage over TFSAs.  Why?   Because the time value for money (TVM) concept tells us that a dollar today is worth more than the promise or expectation of a dollar in the future; even more so when you use that tax refund to its full advantage.  In theory and in practice this principle is in overdrive for high-income earners.  I also think maximizing RRSPs work well for folks who have meagre retirement savings or no company pension plan to help them out

I guess it goes without saying that Canadians who can afford to maximize both RRSP and TFSA contributions would be doing very, very well.  Good on them to do so.  The reality is many Canadians simply don’t have enough cash to accomplish that.  I’m one of them.  In terms of expenses:

• I have a mortgage to pay off,
• I have a new loan to pay off,
• I want to save for retirement but I also want to travel and live for today.  Life is short after all.

While retirement planning via indexing and dividend investing is near and dear to my heart, so is debt management.  Maybe it’s the same for you?  I don’t make a huge salary but a modest one.  For the 2011 tax year, RRSP contribution limits are 18% or a maximum of $22,450.   For example, even if I’m making $45,000 per year that 18% equates to $8,100.  I don’t know about you but I think $8,100 is a big chunk of change to sock away year after year and reinvest all the tax returns from it.  While the TVM concept rings true to me I question whether putting everything I have into a tax-deferred vehicle is wise when:   I have big expenses today, I have some guaranteed retirement income from my defined pension plan at work and I have an amazing tax-free tool (TFSA) at my disposal with very few strings attached.

Most people assume that they will be in a lower tax bracket when they retire since they’ll be making less income in their golden years than working today.  This is not always the case.  A retiree with a decent company pension plan, getting Canada Pension Plan (CPP) income and some Old Age Security (OAS) could easily find themselves in a clawback situation.  Recall, RRSP income can create clawbacks on some income-tested programs.  Withdrawals from a TFSA on the other hand, do not.  Based on my situation, if I busted my butt to create a large RRSP nest-egg, I’ll have to crack it eventually and pay close to or more than 30% tax on withdrawals.  I’ve read about some high-income seniors with large RRSPs who are being taxed close to 50% on their withdrawals.  I don’t even pay 50% tax now, why would I want to pay that much when I’m on a fixed-income in my senior years?

Another compelling reason for not maximizing my RRSP:  over time our fine government will likely find a way of raising personal tax rates.  I just don’t see them taking a major dive over time, as I approach the retirement age, do you?

For these reasons; my personal finance situation, my strong desire to reduce debt long before retirement and my lack of trust in our government when it comes to taxation laws, I’ll be maxing out my TFSA long before maximizing my RRSP.   While I’ll still contribute to my RRSP, monthly I might add, I won’t maximize it but optimize it instead.  I’ll contribute just enough to avoid paying any additional income tax each year. Any small tax refund received instead of being reinvested will be used to pay down my mortgage.   Looking towards my retirement 20 years down the road, my goal is to keep my taxable income as low as possible; avoid growing some oversized nest-egg that must be hatched, cashed-out, redeployed to a RRIF and pay taxes on.

I cannot predict the future many years from now let alone what’s going to happen later today.  What I do know is based on my current situation and what I’ve forecasted for, maximixing TFSA contributions outweigh RRSP contributions.   Do you feel or think the same?  Check out this tool courtesy of Retirement Advisor and run some math for yourself. I think you’ll be surprised by the results.

In the end, financial planning is personal.  What might work me might not work for you.  What I believe in today might change over the years as my needs change.  Maybe I won’t have that 30-year pension like I think I will.  What I can only recommend is for you to look at your own retirement income needs and determine the best path to achieve them.  Nobody cares about your financial well-being more than you do.  With that, be reminded that TFSAs are a complete tax-free gift everyone can benefit from. My plan is to exploit this account for as long as the government lets me.  I hope you consider doing the same

Someday on this blog I might share the other conversations we had during our long drive to and from Myrtle Beach.  At least with this topic, I don’t need any adults-only disclaimers!

Ok, now that I’ve opened up that can again, tell me your thoughts!

What investment vehicle are you partial to and why?   Any feedback or comments for my strategy?

Thanks for reading and sharing this article.

This article is not going down that road since as Mike Holman from Money Smarts Blog nicely put it, the question “…is a tough one, because there are a lot of variables to consider.”   Indeed.    

For example, if you’re in a low tax bracket it might make sense to use the TFSA.  You maximize your TFSA while growing RRSP contribution room and when your income rises, you can start contributing to your RRSP to defer tax and lower your marginal tax rate.  If you’re already in a moderate or high tax bracket you might consider using both accounts; do your best to defer taxes now (RRSP) and also defer taxes forever (TFSA). 

What I’d rather write about today, is our evolving approach to use our TFSAs as a haven for Canadian dividend-paying stocks. 

With the TFSA contribution room jumping up another $5,000 this past January, we’re going to add more dividend-paying stocks to these accounts in 2011 and beyond.  After looking at the numbers and some minor tax implications, we couldn’t think of many reasons not to. Sure, we will lose any ability to claim the Canadian dividend tax credit but then again we’ll earn juicy dividends tax-free.  The latter seems better to me.   Unfortunately we’ll have some capital gains to pay in the 2011 tax year but that can’t be avoided from what I understand unless we’re transferring stocks into the TFSAs at a loss. When unregistered shares are moved to the TFSA, our friends at the Canada Revenue Agency considers the shares sold at their fair market value (FMV) and the shares bought in the TFSA at their fair market value. This means I will have a taxable capital gain next year.  On the other hand, if I transfer shares at a lower price than I paid for them, the capital loss will be denied because I cannot apply this loss against a capital gain.  When it comes to the TFSA, a loss is just that. This is the minor tax implication I referred to above; not the end of the world.

My plan over time is to transfer some of my Canadian dividend-payers into my TFSA to shelter the dividends paid.  I’ll keep some stocks unregistered as the contribution room rises and/or when we can afford to buy some different dividend-payers for the TFSA.  We’re trying to save for the future but also pay off our large mortgage debt and live for today, so we need to strike a balance here.  In any event, I’ve got a few dividend reinvestment plans (DRIPs) running to make optional cash purchases of Canadian stocks when I want to, commission-fee, so I’ll continue that process to build up my volume and diversified list of dividend-payers. When I have some free contribution room in 2012 and the following year, I’ll slide a few stocks into the TFSA.  As TFSA contribution room continues and hopefully rises, I will deplete some of my unregistered holdings.

The plan is to have some tax-free income as we get older, hopefully rising income at that from great companies like TransCanada, Bell, Enbridge, Bank of Nova Scotia and Fortis who have rising earnings and reward their shareholders accordingly every year.

Another bonus to sheltering the dividend income in our TFSAs?

TFSA withdrawals in retirement won’t be considered income in the eyes of the Canada Revenue Agency; they really are our friends!   TFSA withdrawals will not affect government benefits such as OAS (Old Age Security). Honest, check it out!

With TFSAs there are certainly many options. Instead of debating all the pros and cons of each, take what you can from this government gift and seize the advantages of both tools in your financial planning toolbox.

What do you think of our strategy? 
What are you planning to use your TFSA(s) for?

Thanks for reading and sharing this article.

Earlier this year, I made a small purchase of H&R Real Estate Investment Trust (REIT) for half of my 2010 TFSA contribution. I don’t normally watch my TFSA investments, but after casually looking at where HR.UN is today, I must say they’ve had a pretty fine year.

Recall H&R REIT is a TSX-listed, open-ended Real Estate Investment Trust. H&R holds interests in 33 office properties, 118 single-tenant industrial properties, 124 retail properties and 3 development projects, principally in the Greater Toronto Area. Locally in my hometown, H&R REIT owns the Place Bell/Bell Place in Ottawa. It is leased to tenants such as Bell Canada, Public Works of Canada, Accenture and Gowling Lafleur Henderson LLP.

HR.UN has been paying distributions since 1997 and there’s nothing to suggest distributions will be reduced anytime soon. In fact, they increased distributions this summer – H&R nows pay investors $0.07 per unit per month (up from $0.06 earlier this year). Annualized distributions are now at $0.84, creating a tidy yield over 4.5%. Since my purchase in March 2010, H&R REIT is up about 20%.

Are REITs skyrocketing in price because of the brave new world income trusts will face in a few months?
Are REITs like H&R undervalued and folks are snapping them up?
Are REITs overvalued and everyone is doing what they normally do, buying when prices are higher?

To be honest, I don’t know. What I do know is that for many years, HR.UN has been a core holding of many REIT ETFs, such as XRE and given I would need to pay an MER to own XRE, I’d rather pay no fee and own part of the company outright. You can see XRE’s top holdings here:

 

Tenants in H&R REIT properties aren’t going anywhere soon, therefore neither am I. The longer I stay a financial tenant of HR.UN, I’m convinced, the longer I will get paid for it.

What are your thoughts about REITs? Got a theory about their runup this year?
Are you a fan of REITs?

Cheers!
Financial Cents

Thanks for reading and sharing this article.