RRSPs and TFSAs: making the annual choice

If there is one invariable “rule” of financial and retirement planning of which most Canadians are aware, it is the unquestioned wisdom of making regular contributions to one’s registered retirement savings plan (RRSP). And it is true that for several decades the RRSP was only tax-sheltered savings and investment vehicle available to most individual Canadians.

In 2009, however, that reality changed with the introduction of Tax-Free Savings Accounts (TFSAs). Since then, taxpayers have had a choice of which savings and investment vehicle better meets their short-term and long-term tax and personal finance objectives, and this is the time of year when most Canadians must make that choice.

It should be said that there’s nothing wrong, and a lot right, with making the maximum allowable contribution to both of one’s TFSA and RRSP every year. However, doing both assumes the availability of a level of discretionary income that just isn’t the financial reality in which most Canadians live and plan. In addition, there are circumstances in which making a contribution to one type of plan or the other is clearly the better choice, and sometimes the only choice. Some of those circumstances are as follows.

For Canadians over the age of 71, there is no choice. All individual Canadians must collapse their RRSPs by the end of the year in which they turn 71, and no RRSP contributions can be made after that time. A TFSA is the only tax-sheltered savings vehicle to which taxpayers over age 71 can contribute. Many of those taxpayers, however, have transferred their RRSP savings to a registered retirement income fund (RRIF) and are required to withdraw a specified percentage of funds from that RRIF each year. For taxpayers who are in the fortunate position of having such income in excess of current cash flow needs, that excess can be contributed to a TFSA. While the RRIF withdrawals must still be included in income and taxed in the year of withdrawal, transferring the funds to a TFSA will allow them to continue compounding free of tax and no additional tax will be payable when and if the funds are withdrawn. And, unlike RRIF or RRSP withdrawals, monies withdrawn in the future from a TFSA will not affect the planholder’s eligibility for Old Age Security benefits or for the federal age credit.

The minority of working taxpayers who are members of registered pension plans (RPPs) will also likely find savings through a TFSA the better or even the only option. The maximum amount which can be contributed to an RRSP in a given year is generally 18% of the previous year’s income, to a specified dollar amount ceiling. However, any allowable contribution is reduced, for members of RPPs, by the amount of benefits accrued during the year under their pension plan. Where the RPP is a particularly generous one, RRSP contribution room may be minimal, or even non-existent, and a TFSA contribution the logical alternative.

At the other end of the age spectrum, younger Canadians whose savings goals are likely more short-term are usually better off saving through a TFSA. Where savings are being accumulated for an expenditure which is likely to occur within the next five years (e.g., putting together money for a new car or for a down payment), the TFSA is clearly the better choice. Taxpayers in that situation are sometimes tempted to make an RRSP contribution instead, in order to get a tax refund, and then to withdraw the funds when the planned expenditure is to be made. However, while choosing that option will provide a deduction on this year’s return and probably generate a tax refund, tax will still have to be paid when the funds are withdrawn from the RRSP a year or two later. And, more significantly from a long-term point of view, using an RRSP in this way will eventually erode one’s ability to save for retirement, as RRSP contributions which are withdrawn from the plan cannot be replaced. While the amounts involved may seem small, the loss of compounding on even a relatively small amount over 25 or 30 years can make a significant dent in one’s ability to save for retirement.

The greatest tax benefit of contributing to an RRSP is realized when contributions are made when income (and therefore tax payable) is high, and the intention is to withdraw those funds when both income and the rate of tax payable on that income is lower. Where that’s not the case, saving through a TFSA can make more sense, as in the following situations.

Taxpayers who are expecting their income to rise significantly within a few years — e.g., students in post-secondary or professional education or training programs — can save some tax by contributing to a TFSA while they are in school and their income (and therefore their tax rate) is low, allowing the funds to compound on a tax-free basis, and then withdrawing the funds tax-free once they’re working, when their tax rate will be higher. At that time, the withdrawn funds can be used to make an RRSP contribution, which will be deducted against income which would be taxed at the much higher rate, generating a tax savings. And, if a need for funds should arise in the meantime, a tax-free TFSA withdrawal can always be made.

Lower income taxpayers, for whom there isn’t likely to be a great difference between pre-retirement and post-retirement income are likely better off saving through a TFSA. That’s especially the case where those taxpayers may be eligible in retirement for means-tested government benefits like the Guaranteed Income Supplement or tax credits like the GST/HST credit or age credit. Withdrawals made from an RRSP or RRIF during retirement will be included in income for purposes of determining eligibility for such benefits or credits, and lower-income taxpayers could find that such withdrawals have pushed their income to a level which reduces or eliminates their eligibility. On the other hand, monies withdrawn from a TFSA are not included in income for the purpose of determining eligibility for any government benefits or tax credits, so saving through a TFSA will ensure that receipt of such benefits is not put at risk.

As is the case with most tax and financial planning questions, there isn’t a universal right or wrong answer when it comes to decisions on contributing to a TFSA and/or an RRSP. What is certain, however, is that the best choice for any individual is the one which takes account of their particular tax and financial realities and prospects — both current and future.