It’s alphabet soup time out there. Ads everywhere telling you to top up your TFSA overriding the usual February cacophony of RRSP season.
What are you supposed to do? Either ? Both? If you have limited funds which one gets priority?
Many of us are sitting here today looking at RRSP accounts that are still slightly battered from all the recent upheavals, although I think most of us can see the light at the end of the tunnel. But disillusioned by the past year and a half, we ask if we are ready to go down that path again.
At the same time, those near to retirement look at the measly $5,000 annual limit on a TFSA and laugh. There isn’t enough useable space to make a realistic difference in anyone’s immediate plans.
What to choose actually depends on a number of factors; What is your current tax rate? What is the tax rate are you likely to pay in retirement? How old are you? Do you have a pension? What are your current savings? Do you have an emergency fund?
As guidance, I’ll lay out a couple scenarios.
1) 50 year old management type with a good pension and current RRSP holdings, with the house almost paid off.
a) This person is currently in a high tax bracket, and likely to be in a fairly high tax bracket in retirement. Pension income splitting will reduce a couple’s tax burden, and allow them full benefit of their retirement income. Advice – concentrate on the debt, and funnel extra savings to a TFSA which can provide the “fun money” which will make retirement more enjoyable.
b) If you are single or have a spouse who will also have substantial post retirement income, income splitting isn’t likely to help you very much. Advice – forget the RRSPs entirely, they will just create a bigger future tax burden. Pay off the debt, max out TFSAs and if there is still ability to increase savings, investigate unregistered corporate class mutual funds which have a number of tax deferral advantages. Don’t forget the preferential tax status given to Dividend income.
2) 35 years old,with an annual income less than $35,000, no current savings. 20 years left to pay on a 25 year mortgage amortization. A few bucks in an RRSP, no other current savings, no emergency fund.
a) An annual income less than $35,000 is sort of the cut off tax bracket where RRSP contributions are of questionable value. The tax refund you get today, will be pretty well entirely eaten up by the tax you will pay when you start withdrawing the money in retirement. The lower your income the less efficient the RRSP becomes. Advice – get a TFSA to do double duty. Immediate savings can function as an emergency fund because withdrawals will not be penalized. Long term, the TFSA will replace the RRSP for this person, and all income withdrawn from it will be tax free in retirement, which will not affect the person’s eligibility for programs such as OAS. For this person the focus should be on saving, build that nest egg, protect against emergencies. The mortgage, which will pay itself off over time, will be done well before retirement, I wouldn’t worry about it. The trick here is avoiding further debt.
3) Young person, just starting out, lower income, good prospects for the future, no savings, renting. Advice – no question, max out the TFSAs. When the time comes to buy a home, the down payment can be withdrawn from the TFSA without all the headaches of the RSP Homeownership plan. Not only does it not have to be repaid, but you get the available room back the following year, so you are not penalized. During the growing and accumulating years the TFSA can act as an emergency fund, and in the long term will provide tax free income in retirement exactly as above. If this young person does move up in income and tax brackets there may come a day when the tax deduction of an RRSP contribution would be beneficial, however I would continue to advise maxing out the TFSA first.
What to avoid – Tax Free Savings Accounts which are set up like a plain jane savings account, paying pitiful daily or monthly interest. Forget it. At current (and foreseeable likely future) interest rates, these accounts are pointless. The amount of income which could possibly be generated isn’t worth the effort of protecting. We are talking pennies in tax savings here folks. Most of us alive today aren’t likely to live long enough for this to do us any good at all.
What to do – Get a Tax Free Savings Account which is set up like a regular investment account at your local bank, brokerage or investment dealer. Then treat it exactly like you would an RRSP. Same type of investments. GICs, mutual funds, ETFs, stocks, bonds – whatever sets your little heart afire. Think long term, but always keep a little short term money in there on the side in a money market fund or short term GIC, just in case.
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