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:
- 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:
- 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, maximizing 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?