Starting in January 2009, Canadians will have access to a new investment vehicle called the tax-free savings account (TFSA). Ads for these new accounts have been popping up everywhere, and people seem to be touting them as the greatest thing since sliced bread. Some have said the TFSAs are even superior to the traditional Registered Retirement Savings Plan (RRSP). For example, a recent Yahoo Finance article had the following expert advice:
- People making $35,000 or less are often better off with a TFSA than an RRSP
- People with pensions are often better off with a TFSA than an RRSP
- High income earners whose tax brackets won’t fall significantly after retirement may be better off with a TFSA than an RRSP
The biggest problem with many of the articles I’ve seen is they make recommendations, like the ones listed above, without really explaining the rational behind them. Could TFSAs really be better retirement vehicles than RRSPs? Let’s see if we can prove these claims.
Account Comparison
The mechanics of the two account types are straightforward:
| TFSA | RRSP | |
| Tax Break At Contribution Time | No | Yes |
| Contribution Limit | $5,000 | 18% of previous year’s employment income, up to $20,000 |
| Gains Are Tax Sheltered | Yes | Yes |
| Unused Contribution Room Carries Over | Yes | Yes |
| Withdrawal Rules | Money withdrawn cannot be replaced until subsequent year | Money withdrawn cannot be replaced (with a few exceptions), and withdrawals must start by age 71 |
| Taxes on Withdrawal | None | Taxed as income |
Ignoring the contribution limits and withdrawal rules, the real difference between these accounts is when the money is taxed. Taxes on RRSP contributions are deferred until withdrawal time. So if your income will be lower in retirement (not a bad bet), you’ll pay less tax compared to a TFSA. But even if you’re in the same tax bracket, RRSPs still have an advantage. Remember that at contribution time, the tax break for RRSPs is at your marginal (highest) tax rate. But at withdrawal time, thanks to our progressive tax system, the first chunk of income you pay no tax, the next chunk you pay some tax, etc, making your average tax rate less than your marginal tax rate.
This difference in tax rate means that an RRSP will always outperform a TFSA, right? The answer is: yes but… To explain, let’s go back to scenarios from above (I’ve invented some more concrete pseudo-representative numbers).
Performance Comparison (Scenario #1)
| Investment Amount | $3,000 |
| Investment Frequency | Once a year |
| Time Until Retirement | 25 years |
| Income Now | $35,000 |
| Company Pension Income at Retirement | $0 |
| Annual Rate of Return (minus Inflation) | 5% |
The number of years your savings would last would be something like:
| Desired Gross Income in Retirement | Unsheltered Only |
RRSP Only | TFSA Only |
| $35,000 | 9.3 | 11.3 | 16.7 |
| $30,000 | 13.8 | 17.9 | 37.8 |
Hmm… If the RRSP is more efficient, why does the TFSA outperform the RRSP? The difference is government benefits. In all three situations you would get the same amount of Canada Pension (CPP) and Old Age Security (OAS). The difference is, with the TFSA you also get Guaranteed Income Supplement (GIS) because TFSA withdrawals aren’t treated as income. Also, the RRSP doesn’t have any tax advantage over the TFSA because all of your income is in the lowest tax bracket.
Verdict: Lower income earners (less than $39,000) with no pensions are much better off with a TFSA than an RRSP. Breakeven is somewhere around $60,000.
Performance Comparison (Scenario #2)
| Investment Amount | $1,000 |
| Investment Frequency | Once a year |
| Time Until Retirement | 25 years |
| Income Now | $50,000 |
| Company Pension Income at Retirement | $30,000 |
| Annual Rate of Return (minus Inflation) | 5% |
The number of years your savings would last would be something like:
| Desired Gross Income in Retirement | Unsheltered Only |
RRSP Only | TFSA Only |
| $50,000 | 6.8 | 8.8 | 8.8 |
| $45,000 | 20.1 | 37.1 | 37.1 |
This time, the pension income negates the GIS benefit, and thus the advantage of the TFSA. But the pension income negates the advantage of the RRSP because the RRSP withdrawals end up being taxed at the same rate as at contribution time. This leads to identical performance between the two.
Verdict: Middle income earners with pensions will not likely be significant better off (or worst off) with TFSAs, assuming equal contributions. TFSA do have the advantage that contribution room is not reduced by pension contributions, like RRSPs.
Performance Comparison (Scenario #3)
| Investment Amount | $10,000 |
| Investment Frequency | Once a year |
| Time Until Retirement | 25 years |
| Income Now | $80,000 |
| Company Pension Income at Retirement | $0 |
| Annual Rate of Return (minus Inflation) | 5% |
The number of years your savings would last would be something like:
| Desired Gross Income in Retirement | Unsheltered Only |
RRSP Only | TFSA Only |
| $80,000 | 10.5 | 17.2 | 14.6 |
| $60,000 | 16.9 | 42.6 | 27.7 |
I’m actually cheating here because the contribution limit for the TFSA is $5,000 per year, but the results are still interesting. Even though CPP benefits with RRSPs are reduced starting at $66,000, the tax advantage of the RRSP still gives it a big advantage.
Verdict: Higher income earners are definitely not better off with a TFSA compared to an RRSP, even if they’re not in a lower tax bracket in retirement.
Conclusions
Advantages of RRSP:
- More tax efficient for those earning more than $40,000, except if you’ll will be in a much higher tax bracket after retirement (which most of us won’t have to worry about
- Higher contribution limits than TFSA for anyone earning more than $27,777
Advantages of TFSA:
- Able to collect GIS if CPP / pension income will be less than $15,000
- Money can be withdrawn and recontributed at any time without penalty
- Doesn’t require employment income to earn contribution room
- Contribution limit not reduced by pension contributions
- Can continue to contribution after retirement, and no forced withdrawal
So does the TFSA make RRSPs obsolete? Clearly not. But TFSAs obviously complement RRSPs very well.
For those earning less than $50,000, the TFSA is probably the better choice. For those earning more than $70,000, the RRSP has a big tax advantage. Ideally people would use both their RRSP and TFSAs to full advantage. But since only 10% of people currently maximize contributions to their RRSP, this simply isn’t going to happen. My fear with TFSAs is that the ease of withdrawal will encourage people to skim from their TFSAs (and thus their retirement) more than they would from their RRSPs…
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