Tax-Free Savings Accounts versus Registered Retirement Savings Plans

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In January 2009, the federal government created an additional tax-effective vehicle for Canadians to save called the Tax-Free Savings Account (TFSA). This registered savings account is available to all Canadian residents age 18 and over from all income levels.

In some ways, the TFSA is similar to a Registered Retirement Savings Plan (RRSP) in that investment earnings grow within the account tax-free.

But unlike an RRSP, contributions are made on an "after-tax" basis so you can't claim these contributions as a tax deduction. On the other hand, withdrawals from a TFSA are tax-free whereas withdrawals from an RRSP are taxable.

Let's compare the details of a TFSA to an RRSP.



So which is the better choice? A TFSA or an RRSP?

Let's meet Peter. Peter is single, lives in Saskatchewan and currently earns $40,000 per year. He expects to have 70% of his current income (adjusted for inflation) during retirement. Given his income level and the broad tax brackets in his province, he can expect to face a 26% tax rate both now and during his retirement.



Assumptions:

• Income is not in the range where RRSP contributions or withdrawals impact any government benefits.
• Investment rate of return is 5% per year from year of contribution to year of withdrawal.

So for Peter, using a TFSA or RRSP would result in the same income in retirement

Now let's meet Sonia. Sonia lives in Alberta where she earns $94,000 each year. She plans to replace 80% of her current income in retirement (adjusted for inflation). Her current tax rate is 36% and that tax rate expected to fall to 32% with her reduced income in retirement. Her income during retirement falls in the range where the Old Age Security (OAS) clawback can be expected to apply.



Assumptions:

• OAS clawback applies to RRSP withdrawal of $4,887 at a clawback rate of 15% which is $733 before tax or $498 after tax.
• Investment rate of return is 5% per year from year of contribution to year of withdrawal.

For Sonia, she will receive more income in retirement by using a TFSA.

And finally here is Marc. Marc and Susan are married and live in Ontario. He earns $45,000 and she earns $40,000. They both plan to have 60% of their respective current income (adjusted for inflation) during retirement. Their children are now grown. He currently faces a tax rate of 31.1% but during retirement, the tax rate can be expected to be approximately 21% due to his lower income at that time.



Assumptions:

• Marc will receive the full OAS benefit since his income is well below the level where he might attract the OAS clawback seen in the previous example.
• His combined family income with Susan leaves them above the level where they might expect to receive any government paid GST benefit or Guaranteed Income Supplement (GIS) benefit during retirement. As such, use of RRSPs will not impact Marc's income-tested benefits.
• Investment rate of return is 5% per year from year of contribution to year of withdrawal.

Marc will be better off if he invests in an RRSP for retirement.

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Ideally, it would be great if you could make full use of both your RRSP and TFSA! But most Canadians can't afford to.

If you have to choose, you should consider your tax rate when contributions are made and your tax rate when you make your withdrawal(s) as well as the impact on any government income-tested benefits.

TFSA vs. RRSP calculator

Considering the appropriate tax rate for your province and the appropriate benefit clawback rules requires gathering figures from several sources and then doing the calculations.

RetirementAdvisor.ca Inc. has developed a TFSA vs. RRSP calculator which can be found at www.retirementadvisor.ca/tfsa-rrsp. The calculator takes into account your individual circumstances including your province, income and family situation and then tells you whether a TFSA or RRSP works out better for you financially.

TFSA vs. RRSP by Income Range

Here is a summary of income ranges when a TFSA and/or an RRSP is more financially beneficial. This table assumes that your retirement income will be approximately 70% of your income during working years, after adjusting for inflation.



Conclusion

This article has outlined the respective rules for a TFSA and an RRSP. The two differ in many important ways. It's worth emphasizing that a financial comparison of TFSA versus RRSP is one important consideration when making a choice between the two. It is also important to remember that the TFSA is a very flexible tool with fewer restrictions than an RRSP.

Author: Teena Dawson, www.teenadawson.com and James Woodger