Friday, February 9, 2018
I have been quoted in the past as saying everyone should have a Tax-Free Savings Account, everyone. I stand by that claim. The reason is simple, no taxes ever. Now while I stand by my claim, I still believe that the RRSP is a thing of beauty as well. When the TFSA was introduced in 2009 it gave savers and investors another option for their hard-earned money. With many, all this did was muddy the waters and make their savings decisions more confusing. I strongly believe in both products but that doesn’t mean that everyone can have both. For many, the extra money they have is not enough to maximize both vehicles. In this post my aim will be to show you who should use the TFSA and who should opt for the RRSP. I will give some examples of typical Canadians and what they should focus on when it comes to their savings dollars.
Canadian #1
Samantha (Ontario)
Age: 25
Family: No kids, no spouse, just a cute puppy
Income: $30,000 annually
Maximum TFSA contribution: $5,500
Maximum RRSP contribution: $5,400 (30K * 18%)
Goals: Begin saving money, build up a nest egg, pay off student debts, possibly buy a home by 30, secure stable employment, grow within that employment and make more money.
Budget: Through careful budget planning Sam has determined that she can only afford to save $100 every pay cheque or $2,600 a year.
Where should Sam put her money?
The simple answer to this question is Sam should put her money into the TFSA. Let me show you how I came to that conclusion.
If Sam put her money into the RRSP this would happen:
$2,600 would generate an instant tax savings of $521
- This is due to her income being lowered from $30,000 to $27,400 with her contribution and therefore less tax being paid that year
By the time she is 30, her $13,000 of contributions will have grown to $15,818.98 if she obtains a 6% rate of return on her money. That is $2,818.98 worth of growth. This is true for the TFSA as well.
If she goes to withdraw her money at age 30, for any reason, she would have to pay taxes of $3,319.81 due to the withdrawal. This is if her income stayed the same, $30,000.
This lowers her amount saved from $15,818.98 to $12,499.17. She did, however, save $2,605 over the 5 years in tax deductions.
TFSA ~ RRSP
Amount Contributed:$13,000 ~ $13,000
Interest Earned 5 Years (6%):$2,818.98 ~ $2,818.98
Tax Amount Saved:$0 ~ $2,605
Tax Paid on Withdrawal:$0~$3,319.81
Total Amount at Withdrawal:$15,818.98 ~ $12,499.17
Total Amount if Tax Deduction Reinvested:N/A ~ $18,755.91
New Amount of tax if withdrawn:N/A ~ $4,185.51
Final Amount (If reinvested return):$15,818.98 ~ $14,570.40
TFSA Calculator – Get Smarter About Money
As you can see Sam, ends up on top with the TFSA. The main reason for this is because her marginal tax rate is the same when she withdrew the money. She only comes close to the TFSA amount if she were to reinvest her deduction every year when she received it. If she does not, she ends up with a total that is far less. With her goals of saving money, building up a nest egg, paying off student debts, and possibly buying a home by 30, the TFSA is the right choice. The only benefit for her with the RRSP with her limited income would be if she utilized the RRSP Home Buyer’s Plan to fund her down payment. She would then have to pay back the RRSP loan amount over 15 years, as I mentioned in Wednesday’s post.
The Home Buyer’s and Lifelong Learning Plans – Budget Boss
Conclusion:
Because of Sam’s lower-income sticking with the TFSA should be her best bet. It also coincides more closely with her goals and possible future needs. She can also reclaim her contribution room in the TFSA the following year if she withdraws money. With the RRSP, contribution room is lost forever if money is withdrawn.
Canadians #2
Dave and Cindy (Ontario)
Age: Both 45
Family: 2 kids, Paul-7 and Beth-5
Income: $100,000 annually combined (50K each)
Maximum TFSA contribution:$5,500 * 2 = $11,000
Maximum RRSP contribution: $18,000 = 9K each (100K * 18% = 18K, 9K each)
Goals: Retire comfortably at the age of 65, have an income of $50,000 in retirement combined with government benefits, leave any left-over money to the children, $5,000 annually to travel during retirement, have home paid off by retirement
Budget: Through careful budget planning Dave and Cindy have determined that they can afford 200 each from each pay to save for the future which amounts to $10,400 annually combined. ($400 * 26 = $10,400)
Where should they put their money?
This example is a little more confusing. The goals are a little more complex and of course, the contribution amounts are higher. Let’s break down the numbers to see who ends up on top.
If they put her money into the RRSP this would happen:
$10,400 (5,200 each) would generate an instant tax savings annually of $2,962 ($1,481 each)
- This is due to their incomes being lowered from $50,000 to $44,800 with their contributions and therefore less tax being paid that year
By the time they are 65, their $208,000 of contributions ($10,400 * 20 years) will have grown to $402,463.36 if they obtain a 6% rate of return on their money. That is $194,463.36 worth of growth.
We mentioned they wished to have an income of $50,000 combined during retirement. If they both received $15,000 annually per year from government benefits, or $30,000 total, they would only need $20,000 annually from personal savings to make up the gap. Let’s look at the layout if they each withdrew 10K to make that 20K a year gap vanish.
RRSP Savings Calculator – Get Smarter About Money
TFSA ~ RRSP
Amount Contributed Lifetime:$208,000 ~ $208,000
Interest Earned 20 Years (6%):$194,463.36 ~ $194,463.36
Total Amount at Age 65:$402,463.36 ~ $402,463.36
Tax Amount Saved Annually:$0 ~ $2,962
Total tax saved from contributions:$0 ~ $59,240
Annual Income in retirement:$50,000 (20K/TFSA) ~ $50,000 (20K/RRSP)
Amount if Tax Deduction Reinvested:N/A ~ $108,958.92*
Final Amount Age 65:$402,463.36 ~$402,463.36$511,422.28(if tax returns reinvested)
*If reinvested amount is done annually with the same 6% return as the rest of the investment
As you can see, if the money from the tax returns is reinvested, the RRSP comes out on top. If it is not reinvested they both end up in the same spot in the end, but the RRSP gives Dave and Cindy an extra $2,962 annually in extra cash flow. To be able to tell which is best, we must look at the retirement income streams as well.
TFSA ~RRSP
Final Amount Age 65:$402,463.36 ~ $402,463.36 $511,422.28 (if tax returns reinvested)
Annual Income in retirement:$50,000* (20K/TFSA) ~ $50,000* (20K/RRSP)
Extra Tax Paid on Withdrawals:$0 ~ $4,010 ($2,005 extra each/annually)
Total Amount paid by age 90:$0 ~ $100,250
Net amount withdrawn yearly:$20,000 ~ $15,990
Amount left after 25 years**:$6,866 ~ $6,866 $185,624 (if tax returns reinvested)
Net Annual Income in Retirement:$49,182.48 (after tax) ~$45,172.48 (after tax)
*15K each or 30K total of income in retirement from government benefits (CPP and OAS)
**If 20K withdrawn annually with 2% return during retirement, fixed income investments
***Does not take into account the Guaranteed Income Supplement (GIS)
So, as you can see with the RRSP you have less income in retirement based on the tax paid at withdrawal and the TFSA having no taxes upon withdrawal. The TFSA would seem like a better option but there are advantages to the RRSP in this situation. Why would the RRSP be a better option? As shown above, the RRSP generates an extra $2,962 annually in cash flow from the tax deduction during working years. If this money is reinvested into the RRSP annually it generates extra $108,958.92 at the time of retirement. If the same spending patterns are utilized during retirement, 20K withdrawn annually, the estate of Dave and Cindy would be left with $185,624. The TFSA example’s estate would be far less, $6,866 to be exact. This equation is until age 90. If they lived longer than age 90, they would still have funds available to them if they reinvested their returns during their working years. The TFSA account would be drained at age 90.
Conclusion:
Given their goal of earning $50,000 annually during retirement and leaving some money to their children, they would be better off using the RRSP instead of the TFSA. They would either have a greater cash flow during their working years if they didn’t reinvest their tax returns or a greater income in retirement if they did. Also, a greater legacy could be left behind if they did reinvest their tax returns and lived the same lifestyle in retirement. They do not have this option with the TFSA because it is funded with after-tax dollars.
The Wealthy Barber explains: TFSA or RRSP? – The Globe and Mail
As you can see, the answer for whether or not you should use a TFSA or RRSP is not so cut and dry. That is why careful planning is required to make that choice. For the most part, younger people with more modest goals like buying a home, saving for a rainy day or funding a large purchase should stick with the TFSA. People looking to make their dollar go further over the long-term and receive a greater tax-deduction should opt for the RRSP. Ideally, we all would have both, but one thing is for sure, it is never bad to save money and both vehicles offer great benefits to the holder.
Thank you for tuning in for RRSP Week atBudget Boss. Join us next week, where in honor of Valentines Day on February 14th, we will dedicate a whole week to couples and the financial obstacles they may face. If you would like to discuss TFSA’s or RRSP’s, please do not hesitate to contact me at joe@budgetboss.ca. Have a great weekend Bosses!
“After two decades of personal finance reporting, I’ve heard every excuse in the book for not saving money. That said, none of them really hold up – at least over the long term.” – Jean Chatzky
5 Ways to Maximize Your RRSP
Email –joe@budgetboss.ca
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