Senior Financial Planner, Tridelta
Certified Financial Planner, Ed Rempel & Associates
Which is better?
Ed Rempel: For most clients, some sort of combination of the two is usually the best strategy. When deciding which, it comes down to two main factors: First, what your marginal tax rate is today, versus what it’s going to be after you retire. Second, what you use your tax refund for.
How you use your RRSP tax refund is a really big part of the planning strategy. Most Canadians tend to spend their refunds. For the best results, however, you can either reinvest that refund into an RESP or TFSA or follow a gross-up strategy.
Take Rob, for example. He’s expecting a $10,000 bonus in February. Effectively he only gets $6,000 after tax. But he could borrow $4,000 from a line of credit or loan and make a $10,000 contribution to his RRSP; and then get back the $4,000 in refund and almost immediately repay the loan.
An RRSP only really keeps up with the TFSA if you’re grossing-up every single year – if you retire at the same tax bracket as your earning years, the RRSP is 10% behind the TFSA. So grossing-up every single year is the only way an RRSP can keep up with a TFSA.
It’s a planners’ dream if senior clients have a balanced portfolio of both RRSPs and TFSAs when they retire. We could do lot of planning around how much money to take out of each to keep our clients in a lower tax bracket.
Frank Wiginton: The TFSA has very little benefit at this stage, but when we plan out 25-to-30 years it will become a very powerful tax-controlling tool. But at this point in time an RRSP still seems the better option for most people who are in a 30% tax bracket or better.
A majority of our clients are retired or nearing retirement. When we plan 25 years out – depending on their age – we look at the estate planning aspect and how we can use the TFSA to reduce the lifetime tax and death tax. We also see the TFSA as a good option for people who generate very low income.
After a certain level of income RRSPs can give you a much better value. Many times we build out our plans where we actually withdraw more than a minimum out of RRSP accounts to draw them down, so there’s very little remaining on second death. That allows us to control tax rates for our clients to keep them in a very low tax bracket over their retirements. Oftentimes they don’t need that money, so we build it up in their TFSAs. That money, upon second death, can transfer to charities, heirs or beneficiaries without any tax.
Ed: It’s hard to generalize. Each client’s needs and goals are different. If I were to make a generalization, however, I’d say RRSP is still the main savings vehicle for advisors because most of our clients are in higher income brackets. Right now, the biggest shortcoming of the TFSA is it only allows a $5,000 contribution room. Most people need to save more than that for retirement.
However, most people tend to think they’re going to be in a lower tax bracket when they retire, but when you include the four different claw-back programs that could kick in at retirement – most seniors at income levels from $0 to $95,000 are in one claw back program or other – they might effectively be in an even higher tax bracket than when they were working. So it takes a bit of planning to determine each client’s individual circumstance before deciding which is a better vehicle.
You don’t want to build too huge an RRSP, because then it’s very hard to stay in a low tax bracket when you retire. That’s when TFSAs can be useful – just before and after retirement – to make sure clients are in the right marginal tax bracket.
Sometimes it’s better to put in very little into an RRSP just before your client retires and build up tax-free saving or non-RRSP account, especially for the low income clients, and then take out a lot of money when they turn 65, and collect the GIS.
Ideal candidate for TFSA?
Frank: If I had to choose one, I’d say the lower-income group, or the younger clients who don’t have enough money to max out their RRSPs and not much contribution room. Such clients might not be get a tax refund, but the $5,000 is a savings opportunity and if they’re investing every single year and do that for 35 years, at a 6% annual rate of return, and let’s say it grows to $500,000. If you put that amount in an RRSP they’d end up paying more tax in retirement. Even if they got a 15% refund on their RRSP each year, when they RRIF they’d pay 25% tax on it because they’re taking out large amounts and their tax income goes up. They end up paying 10% more using an RRSP, versus a TFSA.
It might make sense to carry forward RRSP ten years from now when they might have substantially higher income, and would fall in a higher bracket. They could then move money out of the TFSA into their RRSP to get bigger tax credits.
Ed: I agree. For people with low income, say under $40,000, TFSA is generally a better option. It’s also a better option for people who make no RRSP contribution, or have a really large RRSP, or have a reasonable RRSP plus a generous pension, because you want to keep your clients in low-income brackets on retirement and desist from building up too huge an RRSP.
If a client intends to retire early, planning becomes interesting and could favor either one of these options, depending on how you approach it. If someone retires at 55, you’ve got 10 years before the pensions and claw backs kick in. During those 10 years, one strategy would be to take money out of the RRSP and save it in a TFSA account for after the client turns 65; because at that point you’re probably going to be in a higher tax bracket than you’d be between 55 and 65. Although, when it comes right down to it, most of our clients between 55 and 65 end up doing some odd jobs or working part time as consultants. In that case you don’t want to take out too much from the RRSP because they’re not really in that low a bracket. It’s amazing how much money you can save someone by making sure they’re always in the right bracket.
Frank: Again it really depends on individual clients and their situations. Some of our clients want to retire at 55 and they’ll take money out of their RRSPs at that stage to start shrinking them. If they don’t need the money, we suggest they put it into a TFSA so it continues to grow tax-free. Vice versa, there may be clients who want to keep their income low because they take up a consulting job or maybe they’re trying to keep their tax rate as low as possible until they retire. I can generate $40,000 virtually for free by taking money out of a client’s TFSA account or I can take money out of his RRSP and pay tax on it. Individual clients will have a preference one way or another and it’s all based around the planner running the numbers who’s able to show them the effects of prudent planning long-term.
The whole situation changes yet again with pension decisions. If a client says, “I’m going to retire at 55, but defer my pension to age 60,” that changes all the math. The pension increases in value because it is deferred five years.
Will the RRSP’s popularity take a hit?
Frank: Because TFSA is an additional vehicle, and tax-free, I do see RRSPs taking a bit of a hit down the road. It’s still five to eight years off, however, and will depend on how the government changes the rules on TFSAs, as the government itself starts to learn more about these accounts.
Ed: There’s a big difference in perception between people who’re getting professional planning advice and average Canadians. From a planner’s perspective, close to half of Canadians would be better off with TFSAs than with RRSPs. For the general public, however, most people will continue to buy RRSPs because they get the tax refund. So the general public will probably use TFSAs as an emergency fund. But people getting professional advice will gravitate toward TFSAs as retirement-planning vehicles.
Frank: Thirty to 40 years down the line, the TFSA contribution amounts will get quite substantial. That’s when planners will be able to completely control income and tax brackets by taking out part of the money from RRSP accounts and the rest from TFSA accounts. There will be all kinds of opportunities to save tax.
This is one of the best things the government has done since the creation of the RRSP to encourage people to save money. But having said that, one of the biggest drawbacks I see in the TFSA is the ease of taking that money out. When people put money into an RRSP, they have the mentality that they aren’t allowed to touch it. With the TFSA they can take the money out any time without paying a penalty or taxes. Consequently, the TFSA loses its effectiveness as a saving tool.
Ed: That’s so right. If the TFSA is a better option for a client, but the client keeps dipping into that account, then maybe it isn’t the right option because it won’t get the client where he wants to go. If you take out $10,000 now with the promise to put it back in two years, and think it’s the same thing, it isn’t because you’ve missed a couple of years of growth, especially because you’ll be tempted to take it out at the worst time. So if your clients are going to keep dipping into their TFSA accounts, it is the wrong growth vehicle for them.
Frank: Another thing both advisors and clients need to be very cautious of is the deposit withdrawal fee for TFSA accounts. A majority of institutions are charging upwards of $50 per withdrawal. So if your clients have to make emergency withdrawals that are unavoidable, that’s one thing, but if they keep dipping into this account they would incur a $50 fee every time they withdraw. That would chew up any income they hope to make in interest.