Since the presentation of the 2008 federal budget, the Tax-Free Savings Account (TFSA) has been receiving extensive coverage in the media and rave reviews from fi- nancial institutions. The perceived advantages of the TFSA are its similarities to the Registered Retirement Savings Plan (RRSP), with the opportunity for high taxadjusted investment returns and tax-advantaged savings for housing or retirement. The TFSA has the added advantage of no withdrawal restrictions.

The standard conclusions about the two accounts as savings vehicles for retirement are that they are almost comparable in terms of wealth accumulation and payouts. However, in some cases, the RRSP appears superior1; further examination of these standard conclusions shows that they may not hold true when the accounts’ specific attributes are considered. Moreover, the different attributes affect the usefulness of these two accounts for different types of retirement savers with different goals. With a proper understanding of the accounts’ attributes, savers will be able not only to choose the right account for themselves but also to enjoy a higher tax-adjusted payout in retirement.

RRSP AND TFSA ACCOUNTS
An RRSP is a tax-deferred (backend load) savings plan for incomeearning Canadians. Contributions to this plan are tax-deductible and grow tax-free until withdrawal. Each withdrawal amount is taxed at the individual’s marginal tax rate. If savers do not start making withdrawals at age 71, they must transfer the funds to a pension vehicle, such as a Registered Retirement Income Fund (RRIF), life annuity fund, or guaranteed fixedterm annuity fund. After age 71, these savers must receive a mandatory minimum distribution every year, which has tax implications. In addition, the government considers withdrawals from RRSPs as income when determining the Guaranteed Income Supplement (GIS) and other federal incometested benefits and credits.

In contrast, the TFSA is a front-end load savings plan. A TFSA holder contributes after-tax dollars that grow without tax consequences, and the withdrawals are tax-free. There is no restriction on withdrawals or contributions in terms of age and income. In addition, if TFSA savers withdraw funds, they may carry forward the withdrawn amount without sacri- ficing the yearly allowable contribution room.

A BASIC ANALYSIS
Most existing comparisons of the RRSP and TFSA are based on the tax rates the savers faced during their working years and retirement years. The analysis starts by presenting the existing conclusions about the accounts. As a base case for our analysis, we consider a saver with an annual wage of $50,000 who works for 30 years and contributes during that time to both a company-sponsored pension fund and either an RRSP or TFSA. She then lives in retirement for another 25 years. The assumption is that all her investments grow at an inflation-adjusted, risk-free rate of 5%2. Finally, we consider the combined federal and provincial income tax rates (using Ontario’s rate for individuals)3, which, for our representative saver, is the marginal rate of 31.15%. The assumption is that this saver allocates $3,000 (pre-tax) annually to either her RRSP or TFSA during her working years. Contributing to her RRSP allows the whole $3,000 to grow on a tax-deferred basis; the same amount, when directed to her TFSA, results in an effective after-tax contribution of $2,065.50. If the accumulated amounts in these two accounts are annuitized in retirement, then the after-tax amounts may be different or the same. Table 1 presents the ratio of the RRSP after-tax annuity amounts to those of the TFSA.

The table shows that if the tax rates are the same during the working years and retirement years, saving in either account results in the same after-tax amounts. If the tax rate declines during the retirement years, the RRSP generates a higher amount (shown in bold fonts) than does the TFSA. However, if the tax rate increases, the TFSA generates the higher amount. In addition, the difference in the magnitude of accumulation for either account is related to the spread between the tax rates during the working years and retirement years. This analysis suggests that savers who expect to have the same or lower tax rates during retirement as during their working years would benefit more from the RRSP and that others would benefit more from the TFSA. However, while this standard analysis is insightful, it does not delineate all the potential and limitations of the two accounts.

EFFECT OF A PROGRESSIVE TAX RATE ON RETURNS
Comparing the RRSP and TFSA as retirement savings vehicles independently from any other sources of income may be misleading under a progressive income tax structure. The average working Canadian with an RRSP or TFSA may also participate in some form of employer-sponsored pension plan. Therefore, during the withdrawal phase in retirement, such a saver can expect to receive income not only from an RRSP or TFSA but also from a pension plan, which may affect the saver’s tax rate. To compare the RRSP and TFSA under a progressive tax rate system, Table 2 considers the annuity amounts that result for our representative saver from different levels of annual pension contributions (the employee’s contribution and employer’s contribution) and contributions to different taxadvantaged accounts (RRSP or TFSA)4. The table shows that depending on the pension contribution level and the RRSP or TFSA contribution level, the after-tax annuitized amounts are different in retirement. Irrespective of the allocation of funds between the pension fund and RRSP, if the total amounts are the same, the after-tax annuity amounts are also the same. For example, the outcome of saving $4,000 in the pension plan and $3,000 in the RRSP (a total of $7,000), and the outcome of saving $5,000 in the pension plan and $2,000 in the RRSP (a total of $7,000) are the same: an after-tax annuity payment of $26,051.92. Funds in pension plans and RRSPs grow on a tax-deferred basis, and their tax treatment in retirement is the same. However, a saver who uses a TFSA rather than an RRSP receives lower payments ($24,623.58 and $25,099.69). In this analysis, the RRSP performs better than the TFSA, even though due to the progressive tax rate for some contribution levels, savers using an RRSP may move to a higher tax bracket (shown in bold font).

The analysis shows that for some savers, an RRSP may produce a higher payout than a TFSA if the saver’s tax rate either decreases in retirement (31.15% to 21.05% or 24.15%) or remains the same as in the working years. These findings are different than the standard findings presented earlier.

A similar analysis using an income level of $80,000. The assumptions about the tax rate during the working years (31.15%) and all remaining assumptions are the same. The results are presented in Table 3.

Due to this saver’s higher income and contribution levels in her working years compared to those of the previous saver, the annuity amount and tax rate are higher. The table shows that when the tax rate for the working years and retirement years is the same (31.15%), the after-tax payouts from these two accounts are the same for both RRSP and TFSA. However, when the saver makes the maximum contribution of $5,000 to an RRSP or TFSA, the TFSA proves to be a better savings vehicle because the increased tax liability resulting from the RRSP distribution leads to a higher tax rate (32.98%). This analysis shows that when other sources of income and a progressive tax system are taken into account, the TFSA may perform better than the RRSP in some cases.

MANDATORY DISTRIBUTION, OPTION TO DELAY, AND BEQUEST MOTIVE
Some savers may be able to start saving early and to contribute larger amounts. They may not need to start withdrawing from the RRSP or TFSA right after retirement. They may want to delay their withdrawals since they have other stable sources of income, such as a substantial income from their company’s pension plan. Given their comfortable financial status, they may even want to bequeath the balances in their RRSPs or TFSAs. For these savers, which is the preferable vehicle? To answer this question, we need to examine the amounts that would accumulate in these accounts over time.

One key feature of the RRSP is the mandatory distribution provision. By the time a RRSP saver reaches age 71, she must transfer her RRSP funds to another account, such as an RRIF, and she must receive the mandatory minimum distribution amounts from it whether or not she needs the income. In the current context, to make the comparison reasonable, the assumption is that the saver receives only the minimum amount from the RRIF, and after paying tax on that amount, saves it in a separate account. The fund grows in that account at a 5% rate, but any growth is taxed annually. This saver now holds her retirement funds in both a RRIF and external account. By contrast, a TFSA saver does not face this mandatory withdrawal requirement; she may keep her funds in the TFSA and has the option to delay withdrawal if she wants to.

Consider a saver with a tax rate of 21.05%. The assumption is that the tax rates for the working years and retirement years are the same and that the pre-tax contribution amount is $3,000. Incorporation of the mandatory withdrawals by following the withdrawal schedule prescribed by the government5 is included for this saver. In Figure 1, the RRIF line shows the combined accumulation in the RRIF and the external account, and the TFSA line represents the accumulation in the TFSA account. It is clear, then, that the accumulation achieved through the RRIF is higher than that of the TFSA in the early part of retirement but that the TFSA amount is higher in the later part. The difference in wealth accumulation becomes substantial. The intuition is simple: because of tax-deferred accumulation, the RRIF is higher initially; however, as mandatory withdrawals occur, the withdrawal amounts are taxed. In addition, the return on savings in the external account are also taxed annually. The TFSA balance, on the other hand, is not taxed at all.

In Figure 2, consider the case when the saver’s tax rate is 31.15%. Here, the conclusions are similar, with one noticeable difference: With the tax rate of 21.05%, the TFSA starts to perform better than the RRSP before the saver reaches age 85, yet at the tax rate of 31.15%, the TFSA performs better after the saver reaches age 85. This difference indicates that the TFSA’s performance in this context is age-dependent, with savers in lower tax brackets starting to enjoy the benefits earlier.

Because life expectancy is increasing in Canada (beyond 80 years), the ability to maximize bequests and delay withdrawals is becoming a valuable option6. From a saver’s perspective, if the funds aren’t needed, the longer they can grow without tax consequences, the better. Therefore, relatively well-off savers with a long life expectancy may prefer to place their savings in a TFSA.

FUTURE INVESTMENT OPPORTUNITIES AND TAX BASE SMOOTHING
A variety of possible investment opportunities arise for savers over time. Some savers may want the opportunity to invest if a new investment opportunity arises during their retirement. If savers use a TFSA, they can withdraw their funds according to their investment needs without any tax consequences. This is not possible if the funds are located in an RRSP or RRIF. Under a progressive tax rate structure, withdrawing funds from an RRSP may move the savers to a higher tax bracket. The aftertax amount that savers receive may cause the savers to pass up the investment opportunity. The situation is even worse for RRIF savers: whenever savers withdraw funds from a RRIF beyond the minimum amount, a withholding tax is imposed, making the investable amount even lower7. If having access to investable funds without tax consequences is a desirable option, the value of the option increases as the potential return from the investment opportunity increases.

Any withdrawal from a pension plan or RRSP leads to an increased tax burden; however, this is not the case for the TFSA. Hence, the TFSA can work as a tool for tax base smoothing if a saver wants to have access to more after-tax income without triggering tax liabilities.

CHOOSE AN OPTION
The introduction of the TFSA in the 2008 federal budget has provoked a substantial amount of discussion about the TFSA’s potential usefulness. This examination focused on the usefulness of the TFSA for retirement savings compared to the RRSP, the standard opinion seems to be that these two vehicles are comparable for retirement savings. However, it has been shown that each vehicle has specific attributes that may be advantageous or disadvantageous for different savers, depending on their income level, contribution level, and purpose of saving (such as bequests). Moreover, the TFSA potentially confers a substantial amount of option value for a saver. Hence, the standard conclusions about the RRSP and TFSA as comparable saving vehicles are not true for all savers.

ENDNOTES
1 in its presentation of the tfsA and rrsp in the 2008 federal budget, Canada’s Department of finance also shows the comparability.

2 We present our analysis using one income level; however, it is possible to conduct similar analysis for other income levels. We expect the qualitative conclusions to be the same.

3 the tax rates are from www.taxtips. ca, which provides a reasonable approximation of the 2008 combined federal and provincial personal income tax rates, including the surtax for ontario. the tax rates are as follows:for the first $36,020, 21.05%; over $36,020 up to $37,885, 24.15%; over $37,885 up to $63,428, 31.15%; over $63,428 up to $72,041, 32.98%; over $72,041 up to $74,720, 35.39%; over $74,720 up to $75,769, 39.41%; over $75,769 up to $123,184, 41%; and over $123,184, 46.41%.

4 We use the maximum contribution amount consistent with the general guideline of 18% of the previous year’s income.

5 the mandatory withdrawal schedule is available at http://www.cra-arc.gc.ca/E/ pub/tp/ic78-18r6/ic78-18r6-e.pdf

6 the data on life expectency is available through http://www4.hrsdc.gc.ca

7 for details on tax withholding, visit http://www.cra-arc.gc.ca/tax/registered/ rrsp-rrif/faq-e.html#withholding

Ashraf Al Zaman, PhD is the assistant professor of finance, Department of Finance at the Sobey School of Business, St. Mary’s University, Halifax. He can be reached at ashraf.zaman@smu.ca.