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I’ll maximize my TFSA first, thanks

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, 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?

Filed in: Goals & Planning, Index Investing, RRSP, TFSA

21 Responses to "I’ll maximize my TFSA first, thanks"

  1. I am with you. TFSA first.

    One of the challenges for many is possibly extrapolating where they would be at retirement to evaluate the tax situation at such time.

    You can always make use of your unused contributions if you wanted later in life and swap some TFSA over to your RRSP in the last years of a high income … You would get a tax refund and you can put it back in your TFSA :) or make use of it …

  2. Echo says:

    That sounds like a fun trip!

    This decision would be a lot tougher for me if I didn’t have a defined benefit pension plan. Since I do, the TFSA definitely gets preferential treatment as far as my savings priorities go.

    I do have about $45k in my RRSP that I saved up before moving into the public sector. Assuming it grows to a few hundred thousand in the next 20 odd years I might use it as part of an early retirement plan and melt down the RRSP from age 55-64.

    • My Own Advisor says:

      It was a great trip Echo. I too, might meltdown the RRSP as part of an early retirement plan. It all depends how those dividend-paying stocks grow and mature for me :)

  3. MOA, this is a GREAT post! Well done..

    Regardless of income I argued explicitly in a previous blog post that an individual is far better off maximizing their TFSA contributions first (before their RRSP):

    http://www.dividendninja.com/tfsa-forget-the-rrsp

    The basic premise is you don’t have to pay taxes on your withdrawals from a TFSA, but you do with an RRSP. In an RRSP, that amount happens to include all your compounded income on top of your original investment – which can amount to a huge amount over time. Then there are all the hassles of converting your RRSP at age 71.

    Whether you are a high income or low income earner, lower tax bracket in retirement or not, you still will pay exta tax on your RRSP withdrawals – so you will always be better off with a TFSA. I know a lot of people will disagree with me on that, but why have extra taxation in retirement, to save taxes now?

    There is one situation where an RRSP contribution makes sense. For people who don’t have secured collateral for a line of credit for investing, or their own home for a HELIOC etc. the RRSP loan makes sense, becuae the interest rate on an RRSP loan is very competitive. Its a cheap way to borrow for investing.

    Cheers!

  4. I am all for the TFSA as well. With the RRSP vehicle you are simply deferring your taxes for the future. Having said that, one might exploit the RRSP in a high income year and withdraw the funds in a year where he loses his job for example. What do you think?

    • My Own Advisor says:

      Hey Mich,

      Totally agree. If one was in a high-tax bracket for one year or many years, I would most certainly try to put lots away in the RRSP. For now, that’s just not me :)

      Thanks for checking in!

  5. S P Brunner says:

    When I stopped working, I had half my money in a Trading Account and half in RRSPs. I had a regular RRSP and a Locked-In one for the bits of pension I got from companies I worked for.

    When I was saving, everyone was pushing RRSPs. Most of the time I was contributing to my RRSP, I was not in the top tax bracket. However, taking money out of the RRSP, I am in the top bracket. I wished there were TFSAs earlier. (I did save tax free in my RRSP over the years, as a number of people have pointed out.)

    If I had to do this again, and had that choice, I would pick the TFSA savings first also.

    • My Own Advisor says:

      That is what I’m worried about, although only a bit, being in a higher tax-bracket in retirement than in my working years because to date, I am fortunate enough to have a defined benefit pension plan. While the tax-deferral today is great I will be paying taxes on withdrawals at some point, when converting RRSP to a RRIF. As Dividend Ninja said, “why have extra taxation in retirement, to save taxes now?” No thanks if I can do something about it. Thanks for stopping by Susan, I continue to follow your dividend investing approach, not to mention success!

  6. Ian Brennan says:

    Correct me if I am wrong, but assuming my taxation rate is 30 percent (for round numbers), and I contribute $1,000.00 to my RRSP, the net cost to me is $700.00 since the government is willing to refund me $300.00. Using the rule of 72, and a return of 7 percent, that $300.00 should double twice over the next 20 years to $1,200.00. Assuming even the same rate of taxation after retirement, 30 percent of $1,200.00 is $400.00. In other words, for every $1,000.00 I contribute to my RRSP that I can leave in the plan for twenty years, I receive $800.00 more than I would in a TFSA.

    Contrary to what was suggested about topping up your RRSP from your TFSA later in life, the power of compounding means contributing more to your RRSP earlier is where the real benefits are achieved.

    • My Own Advisor says:

      Hi Ian,

      Thanks for commenting on my blog. I see your math the same way. Over 20 years, using Rule of 72 @ 7% return on investment that $300 (refund) would double every 10 years and be worth $1200 in 20 years. If the same “rules” are used for the rest of the money, that $700 RRSP contribution will be worth $2800. If you reinvested your $300 refund over 20 years, every year, for sure you’ll be ahead with the RRSP by a bit like I mentioned in my post. More money invested and reinvested early = more money generated overall, we agree.

      My points are these though:

      Over 20 years, instead of $1,000 contributed to your RRSP you only contribute $700 because the TFSA is not pre-tax money like the RRSP is. Over 20 years, using the same “rules” that $700 TFSA contribution is worth $2800, this time all tax-free; same value as the RRSP. You don’t have to pay the government back a cent like most of the $300 refunded, reinvested and compounded for 20 years. During those 20 years you forego the ability to use your $300 refunded each year for your mortgage debt or for investments such as Canadian dividend-paying stocks that get a dividend tax credit; which are far more tax-advantaged investments than any RRSP withdrawal would be. You’re forced to withdraw most of that $1200 earned from the $300 twenty years ago in your golden years and wind RRSP assets down. Not so with the TFSA. If you have enough TFSA assets, you can keep the capital, let the income flow and never wind it down leaving you many more options for your loved beneficiaries. Also, the TFSA money is not impacted by government “income-tested” programs like OAS and GIS whereas the RRSP is. As a senior I want my tax burden as low as possible, regardless what my marginal tax rate is. Thoughts?

  7. My Own Advisor says:

    @The Passive Income Earner

    Thanks for stopping by Passive! Agreed, you can always make use of unused contributions if you wanted to later in life; if you get into a very high income situation. That is nice problem to have but that common I would guess for many Canadians with a mortgage, LOCs and the TFSA contribution room to make use of.

  8. badgerb0b says:

    I kill two birds with one stone and max out my RRSP then use the huge tax return to build up my TSFA.

    • My Own Advisor says:

      Sounds like you have a good plan in place that meets your needs badgerb0b! Good stuff and thanks for stopping by!

  9. @The Dividend Ninja

    Thanks for the support and positive comments!

    I thought your post was also spot-on, most if not all individuals are far better off maximizing their TFSA contributions first (before their RRSP). It doesn’t mean, if you have the financial means, to do both, then don’t, rather everyone can benefit from tax-free money can’t they???

    You and I are aligned; there are hassles with converting RRSPs to RRIFs in the golden years. If I HAVE to do it, I will, but I don’t want to incur more pain than necessary :)

    Thanks for your comment Ninja!

  10. Ian Brennan says:

    I suppose an ability to withdraw the proceeds from an RRSP at a much lower rate than when contributing is the ultimate key. @My Own Advisor

    • My Own Advisor says:

      Agreed Ian. As long as refunds are always reinvested AND you can assure yourself you’re in a low tax bracket come retirement, I believe in the power of RRSPs as well. I’ll put it this way, I’m not stopping my RRSP contributions anytime soon :) Thanks for your engagement in my post!

  11. Risk says:

    All good points, but one major point to consider is that RRSP’s are creditor protected while TFSA’s are not.

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