RRSP VS. TFSA
Feds may soon raise TFSA limit to $11,000, which could affect your investments.
As readers think about the likely doubling of the tax-free savings account limit in Tuesday’s federal budget, many wonder whether it makes sense to move investments from RRSPs into TFSAs.
It’s a war of duelling tax shelters that will intensify. Even if the TFSA limit is not increased to $11,000 a year as Finance Minister Joe Oliver has hinted, the question will keep coming up. Which is better and under what circumstances?
The main difference between the two is that you put after-tax cash into a TFSA, but withdraw the gains tax-free. As a bonus, any withdrawals from the current year are added back to your contribution room next year.
With an RRSP, you get a tax deduction when you put the money in, but pay tax later when you take it out.
“I see the TFSA as a way to avoid a huge tax hit on accumulated RSP savings in later years,” wrote one reader in an email. “Upon death, the TFSA is also transferable without penalty. Do you see the ‘RSP meltdown’ as a viable plan?”
Another reader, Gary, is also thinking along the same lines. He’s 70, his spouse is 65 and their annual income is $57,600. It comes from a combined $3,200 a month from Canada Pension Plan (CPP) and old age security (OAS) and another $1,600 a month from Gary’s RRSP.
Gary has saved $350,000 in his retirement plan and his spouse has $200,000 in hers. They have done well managing the money with an average 5-per-cent annual return over the past decade. Gary withdraws $19,200 a year, which is a little under 4 per cent of the total, so their nest egg is intact. His wife doesn’t withdraw anything.
“Assuming I can also get a 5-percent return in my TFSA, would it make sense to withdraw the maximum (TFSA limit) from each RRSP and put the money into our TFSAs?” he asks.
If Gary does that for 10 years, as- suming a new $11,000 limit, the RRSP draw down of $220,000 over the decade will mean $66,000 in additional tax at their 30-per-cent tax bracket.
But Gary figures that with compounding at 5 per cent a year, the $220,000 would become $326,000 over the period.
At that point, Gary figures the couple could withdraw $32,600 a year for another decade tax free. Their RRSPs will be much smaller and so their taxable income lower. The RRSPs will have been converted to registered retirement income funds (RRIFs) as required by law when they turn 71.
Good idea, bad idea? It could work, says Clay Gillespie, a financial adviser and portfolio manager, with Rogers Financial Group in Vancouver. It all depends on your tax rate.
“If your income is higher in retire- ment, the TFSA would give you more (in your pocket),” Gillespie says. “If your tax rate is lower, the RRSP would give you a higher amount. So anyone considering making the move must answer that question.”
Another reason Gary might want to gradually reduce his RRSP holdings is because in the year he dies the lump sum in his RRIF goes into his estate. This might mean a lot of tax.
If the tax brackets now and later are the same, it’s a wash, but there may be an indirect advantage to TFSAs. Since money in the TFSA doesn’t count as income for tax purposes, using it to live on lowers your taxable income and so the clawback of benefits such as old age security.
As the accompanying chart shows, one size doesn’t fit all and it is a complicated process. Think it through and get some advice. It may save you money in the long run. Adam Mayers writes about investing and personal finance on Tuesdays and Thursdays. Reach him at amayers@thestar.ca.