Why you should use a TFSA to save for retirement
Only half ( 51 per cent) of Canadians aged 45 and older intend to use a tax-free savings account ( TFSA) to provide retirement income, according to the 2020 Fidelity Retirement Survey. They view it primarily as a short- term savings account and lean more on registered retirement savings plans (RRSPS) for retirement investing.
This approach may be a bit shortsighted, though that may only be evident as these Canadians get closer to actually leaving work behind. More and more retirees are discovering that TFSAS, although generally underutilized, are a key component of a well-rounded retirement plan.
There are several ways you can put a TFSA to work. Near-term objectives like buying a new car or saving for a vacation are most typical, as is setting aside cash for a down payment on a home. But when looking longer-term toward retirement, the tax-free benefits of TFSAS really stack up.
“Most Canadians have both short- and long-term financial goals, and when it comes to longterm retirement planning, using a combination of TFSAS and RRSPS is often the way to go,” says Michelle Munro, Fidelity Canada’s director of tax and retirement research. “But getting the mix right can be tricky without the correct kind of advice — particularly when you’re looking so far into the future.”
While a few fortunate people have enough money to max out their RRSP contributions and put money in a TFSA, many more can’t afford to do both. Each account offers relative advantages, depending on your tax rate, the timing of your contributions and when you actually retire. But they both have one thing in common: the earlier you put the power of compound interest to work, the more impressive the potential long-term results.
If you’re just starting your career, or even if you’re further into it and not yet making as much as you one day will, a TFSA usually makes more sense. An RRSP will likely win out later in your career, because that generally includes your highest-earning years.
The big difference between an RRSP and a TFSA is the timing of the taxes you’ll eventually pay. A good strategy is to contribute to an RRSP if your marginal tax rate is higher at the time of contribution than you expect it to be in retirement. That way, you’ll benefit from the deduction today at a higher tax rate, and potentially find yourself in a lower tax bracket in retirement when the withdrawal is included in income.
This is a common scenario for many Canadians, because those who are currently retired generally manage on less than what they made when they were working.
If you can’t yet make good use of that deduction though, a TFSA is the better bet. Not sure what the future holds tax-wise? The good news is you can move your TFSA money to an RRSP at any time without tax consequences.
Unlike with RRSPS, there’s no age limit at which TFSA assets must be withdrawn. With an RRSP, you must convert your plan into a registered retirement income fund (RRIF) or an annuity by age 71 and begin withdrawing at least some of your savings each year.
The bonus here is that TFSA withdrawals will have no effect on income-tested benefits, like old age security (OAS), that can be clawed back once you hit a certain income threshold. This means you can avoid the equivalent of an additional ¹5 per cent tax on the amount withdrawn.
Several other income-tested benefits and tax credits are also clawed back to varying extents, depending on your retirement income. For instance, having more TFSA income to work with may help you qualify for the age amount, a means-tested nonrefundable tax credit offered to those aged 65 and older with an income below a certain threshold.
To further boost retirement savings, for instance, there may be an advantage to intentionally storing up RRSP room and using a TFSA in the interim. Should your income jump, pushing you into a higher tax bracket, TFSA funds can be withdrawn to make an RRSP contribution, creating TFSA repayment room at the same time. This tactic might appeal to young professionals, for example, since their income generally jumps significantly after completing numerous years of training.
Similarly, if you’re a public service worker with a guaranteed pension, you’re really limited as to how much you can put into RRSPS to begin with. Therefore, the TFSA becomes a more viable retirement planning option, with potential contribution room growing by $6,000 every year, regardless of income level and available RRSP contribution room.