During RRSP season, the question always arises: Is it better to contribute to an RRSP or a TFSA? Ideally, both should be maximized each year, and both are part of a long-term wealth building plan. But if you really must choose between one and the other, you’ll need to do some number crunching. So with that in mind, let’s see which savings plan is likely to win the retirement income sweepstakes.
First, you have to know your marginal tax rates. Here are the combined provincial and federal marginal tax rates on earned income in 2012. I’m using Manitoba rates as an example, but they’re pretty similar across the country.
|Combined 2012 federal and provincial marginal tax rates - Manitoba
|over $31,000 up to $42,707
|over $42,707 up to $67,000
|over $67,000 up to $85,414
|over $85,414 up to $132,406
Now, here are some ground rules.
* If your marginal tax rate in retirement is expected to be lower than your marginal tax rate today, the RRSP is always the best option.
* Always maximize the RRSP contributions of the higher income spouse first.
* Consider a spousal RRSP contribution, so that the higher income spouse receives the tax deduction while the money grows in the hands of the lower income earning spouse. The goal is to have two equal incomes in retirement. This comes from having two equal amounts of investment capital in retirement.
* The greatest benefit to the RRSP contribution is reinvesting the refund received. But an even more effective way to do this is by taking a year-end top-up loan, every February, to maximize total RRSP contributions.
Let’s look an example. Suppose Sally earns $85,000 a year and has $5,000 to invest. If she contributes this to an RRSP, at her marginal tax rate of 39.4%, she would receive a tax refund of approximately $1,970. If she invests this same amount of money (that is, $5000) each year for 25 years and earns a rate of return of 5% per year, she would end up with $238,635. Sally would get the same result with a TFSA.
Now suppose Sally chooses to take out a year-end RRSP top-up loan (that is, in February each year) of $3,200. Along with her cash contribution of $5,000, that will make her total RRSP contribution $8,200, for which she receives a refund of $3,230. Notice how the amount of the loan matches the amount of the refund. In this way, Sally is able to make an additional $3,200 in contributions, but it doesn’t cost her anything to do this (other than about $25 in annual interest costs for the short-term loan). Once Sally receives her tax refund, she would immediately pay off the loan.
By making total annual contributions of $8,200, in 25 years’ time at an annual rate of return of 5%, the value of her RRSP would be $391,362. This is an increase of $152,726, or 64% more than what she’d make with her initial $5,000 contribution. This is an highly significant difference in the amount of money Sally would have in the future, and it barely cost her anything to achieve this (other than the short-term interest expense of approximately $625 total over this 25-year period of time – $25 per year in interest costs x 25 years).
Now let’s project forward into retirement. How much after-tax income would Sally receive? Let’s assume a marginal tax rate in retirement of 27.75%.
1. TFSA portfolio: $238,635 x 5% return = $11,931 in after-tax income.
2. Typical RRSP portfolio: $238,635 x 5% return = $11,931 less the tax = $8,620 in after-tax income. In this example, we are not adding the top-up loan, and thus you can see that the TFSA is actually a better option. This teaches us a very valuable lesson: The greatest benefit of the RRSP comes from how wisely you use the refund, as you will see in Point 3 below.
3. RRSP portfolio with top-up loans: $391,362 x 5% return = $19,568.11 less the tax = $14,138 in after-tax income. This method produces over 18% more after-tax income than the TFSA and 64% more income than an RRSP without the annual top-up loans.
Is this a significant difference? Well, think of it this way. If you had $2,207 more after-tax money per year in retirement, would this be a good thing? Could you use this money to enhance your lifestyle, say, take a trip or spend on some other luxury? Of course you could. But now think of this in terms of your total retirement picture. You would have this amount of additional income each and every year over a 20-year period. This works out to be $44,140 more after-tax spendable income in retirement.
How cool is that? The numbers get even larger when you start looking at annual RRSP contributions of $10,000, $15,000 or more.
The best approach for your RRSP and TFSA is determined by the marginal tax rates of the province in which you live. If you are likely to be in a lower marginal tax rate in retirement than what you are in today, the best approach is therefore always to maximize your RRSP contribution first.
Doug Nelson, B.Comm., CFP, CLU, CIM, is a licensed financial planner and portfolio manager at Nelson Financial Consultants based in Winnipeg, Manitoba, and a regular contributor to the Fund Library. Doug is the author of Master Your Retirement, How To Fulfill Your Dreams With Peace of Mind (2012 Edition). You can reach Doug at Nelson Financial Consultants, 102 – 147 Provencher Blvd., Winnipeg, MB, R2H 0G2. Phone: 204-956-0519; Fax: 204-942-6890; Email: firstname.lastname@example.org. Web: www.nelsonfinancial.ca.
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