For many, the discussion of a comfortable retirement may be a worrisome topic. After all, we are working and living longer. Many current retirees say that they have not prepared adequately or at all for a comfortable retirement.
Two of the easiest and most compelling retirement savings plans – the Registered Retirement Savings Plan (RRSP) and the Tax-Free Savings Account (TFSA) – are often overlooked. In Canada, some of the latest statistics show that over $680B remains in unused RRSP contribution room and only around 30 percent of taxpayers have contributed to a TFSA. While there are often debates about which savings vehicle is more appropriate, most investors would be well served to make a contribution to either or both. The opportunity to compound tax-free or tax-deferred income should not be passed up.
The Merits of Tax-Free/Deferred Growth
Comparing the benefits of each savings vehicle to a non-registered account serves as a good reminder of the potential. Let’s take a look at a $30,000 investment today to see how much further ahead an investor would be after 30 years by taking advantage of tax-free or tax-deferred compounded growth. With the TFSA, any contributions are able to grow on a tax-free basis and withdrawals from the plan are not subject to tax. Remember that as of January 1, 2017, eligible Canadians are able to contribute a total of $52,000 towards a TFSA if they haven’t yet used any contribution room. Within an RRSP, investment income is tax deferred as it is not subject to tax until it is withdrawn from the plan.
As you can see from the example above, an investor is ahead by 18.2 percent using the TFSA or RRSP to save for retirement, as compared to a non-registered plan. However, this assumes that the marginal tax rate at the time of the contribution and withdrawal of the funds is the same. In this example, they were both assumed to be 40 percent.
Which is Better?
Both the RRSP and TFSA can be excellent savings tools. Ideally, it is beneficial to maximize contributions to both. However, if the investor is unable to do this, here are some considerations when choosing between the two:
Marginal Tax Rate — Generally, for investors who will have a higher marginal tax rate in the future than at the time of contribution, the TFSA may be a better savings vehicle than the RRSP as no tax will be due upon the withdrawal of funds and the net after-tax proceeds will be greater. If a lower marginal tax rate is anticipated, the RRSP may provide a better result.
Age Limit — RRSP contributions can be made up until the year in which the investor turns 71, at which point RRSP savings must be withdrawn or converted to an annuity or a Registered Retirement Income Fund (RRIF) and minimum withdrawals will need to be made. The TFSA does not have any age restrictions, which may appeal to those retirees who do not need funds immediately at retirement.
Contribution Room — For TFSA withdrawals, any associated contribution room will be available in the following calendar year. When funds are withdrawn from the RRSP and the related taxes are paid (except through the Home Buyers' Plan or the Life Long Learning Plan) contribution room is not replenished.
Income-Tested Benefits – In retirement, withdrawals from the RRSP/RRIF can lead to a clawback of the Old Age Security and other government programs like the Guaranteed Income Supplement.
The Bottom Line?
The RRSP and TFSA are both excellent vehicles to save for retirement. Continue to make them a priority!