When TFSAs were introduced with a $5,000 annual contribution limit in 2009, they may not have seemed to be a very promising retirement planning tool. But just five years later, with a $5,500 contribution limit for 2013 and 2014, TFSAs provide a place for up to $31,000 in cumulative contributions to grow tax-free.
We asked two advisors to share their thoughts on the role of TFSAs in retirement planning, and whether they are becoming a more attractive solution than RRSPs.
Michael Job, CFA
Since their inception, TFSAs have been sold by the government as a complement to existing registered account options, whether RRSPs or RESPs, and I tend to agree with that. They’re another arrow in the quiver.
An RRSP is, and will continue to be, a very valuable tool for generating post-employment income. It allows savers to contribute to an account on a tax-deferred basis and lower their taxable income by the amount contributed in any one year. That’s a benefit unique to the RRSP that the TFSA doesn’t challenge.
For those with extra cash or a portfolio of taxable investments, the TFSA is becoming an increasingly attractive vehicle that allows contributions, investment growth and withdrawals, completely tax-free. People who were 18 when TFSAs were introduced had $31,000 in contribution room as of January 1, 2014. That’s a meaningful amount.
I would advocate contributing to a TFSA over an RRSP for mid- to low-income individuals able only to utilize one or the other. The value of the tax deductibility of an RRSP contribution is lower for an individual whose income is taxed at a lower margin relative to someone whose income is taxed at a higher marginal rate.
Up until retirement, the TFSA provides greater flexibility in that a current contribution could be withdrawn in the future to repay debt or cover an income shortfall and then re-contributed the following calendar year. In the years immediately preceding age 71, if somebody is retired and isn’t accruing much RRSP contribution room, a TFSA looks attractive because contribution room is guaranteed for everyone who is of the age of majority, is a Canadian resident and has a SIN.
The year you turn 71 is the last year you can make a contribution to your RRSP. After that it must either be withdrawn or transferred to an RRIF, or used to buy an annuity.
In retirement, a TFSA can come into play if there’s a shortfall between somebody’s lifestyle expenses and the mandatory withdrawal they need to make from an RRIF. And the other big benefit of the TFSA is that any interest or investment income earned inside it does not impact qualification for federal income-tested benefits such as old age security (OAS) or the guaranteed income supplement (GIS). That can be huge for people who rely on those programs to supplement living expenses.
It is also important to consider the tax implications of RRSPs and TFSAs in the context of succession planning. When RRSPs enter into an individual’s estate, or are passed on to a next-generation beneficiary, their entire value is taxed as income. By contrast, TFSAs are more tax efficient in succession planning, because their value at the time of the original holder’s death is not subject to tax when they are passed on to a next-generation beneficiary.
However, most high-net-worth families are utilizing both accounts in their overall estate plan given that in many cases the size of the RRSP accounts for the older generation family members are currently much higher than their TFSAs. This is primarily because RRSPs have been available for much longer than TFSAs. Also, for most high-net-worth individuals their annual RRSP contribution limit is much higher than the $5,500 for the TFSA.
Of course, the decision about which strategy to use is very situation-specific. To optimize RRSPs and TFSAs in retirement planning, advisors need to work with clients to assess both their income and investment portfolio today and their income and investment portfolio goals for the future.
Christina Anthony, CFA
Vice President, Director, Portfolio Manager
As a general rule, if your marginal tax rate is higher today than what you expect it to be in retirement, then the RRSP makes more sense than the TFSA. The reverse is true if your current marginal tax rate is lower than you expect it to be in retirement. That’s the case no matter how far from retirement you are. However, people may get more clarity closer to retirement about what their income will be and may need to adjust their strategy.
The question for my clients is which of the two savings vehicles is better if you’re at the highest marginal tax rate now and if you will be at the highest marginal tax rate in retirement. Ideally, they should have the disposable income to contribute to both, but if not it’s a toss-up. The tie-breaker may be whether or not you will have such a high level of income in retirement that you would expect to have all of your Old Age Security benefits clawed back. At the margin, you may prefer to put extra money in a TFSA because withdrawals won’t generate extra income and therefore will have no bearing on the income-tested government benefits.
The other increasingly important consideration for high-net-worth families is the role of RRSPs and TFSAs in estate planning. When you look at it through the lens of saving for the next generation, the TFSA is the best. With an RRSP, RRIF withdrawal minimums are eventually forced upon you and the tax deferral stops. With a TFSA, there’s no forced withdrawal and the money can simply keep growing tax-free. Furthermore, it comes out to your heirs with no tax. Right now, couples could be entitled to a combined $62,000 in TFSA contribution room. It’s not unreasonable to assume that over time, some will end up with $1 million or more in TFSAs that can flow to the next generation tax-free.
The tax treatment of investment growth of funds held in RRSPs can be a determining element for some. For example, if you are investing your RRSP entirely in bonds, you are sheltering that interest income from taxation for a period of time. Interest income from bonds is taxed at a higher rate than capital gains on stocks or dividends on stocks so this could seem like a great strategy.
But, if you invested in stocks in the RRSP instead, and the stocks grew by a rate much higher than that of interest on bonds, you would rather these gains have been sheltered in the RRSP because even after tax, these savings are greater than the savings of interest income tax on the bonds.
One more point: there are non-mathematical factors that come into play when analyzing specific situations. If you like flexibility, a TFSA may be the better vehicle. But some people don’t want flexibility because it affects their behaviour. They need the confines of an RRSP, and the certainty that you pay tax when you withdraw, to discipline them not to touch that money.