Money talks: alphabet soup – TFSAs
by Arnold Machel, CFP®
“May he give you the desire of your heart and make all your plans succeed.”
– Psalm 20:4 (NIV)
RRSPs are the classic accumulation account type for retirement. They are among the most appropriate and beneficial tools available to Canadian tax payers and frankly, they are among the best tools for retirement savings in the western world. Lately they have gotten a bad rap as more and more seniors, having forgotten the terrific tax break they got to begin with, now realize that they have to pay taxes on money as they make withdrawals.
Each year the Canada Revenue Agency determines how much more a person can add to their RRSP. It’s a simple formula: 18% of the previous year’s income (up to $26,230 for 2018) less a pension adjustment, if applicable. This amount is then added on to whatever is left of the previous year’s limit, providing a cumulative RRSP limit. Unused room is carried forward, so it can be used in later years if one chooses to do so.
RRSP contributions provide a dollar-for-dollar deduction. That means individuals are taxed as though they never earned the money contributed and that the tax savings is equal to the amount contributed times the marginal tax bracket (see math below) of the contributor.
Income and gains, while in the plan, grow without taxation. Once withdrawn though, every dollar withdrawn is treated as a dollar of income (just like pension income) and is taxed accordingly.
Jane earned $105,000 in 2017 and contributed $10,000 into her RRSP. Typically, she would pay $25,563 in taxes on her income. That’s an average of 24.4%, but her marginal rate (the rate at which tax is owing on the next dollar earned) is 38.29%. That’s not only her tax rate on any extra dollars earned, but also her tax savings on a dollar invested in an RRSP. So, her tax savings on that $10,000 contribution will be 38.29% of $10,000 for a total of $3,829.
To keep things simple and to understand how the taxation works, let’s assume that Jane retired in January of this year and that she earned nothing on her RRSP money last year (so it’s still worth only $10,000). Also let’s assume that she cashes out all $10,000 this year and that her retirement income from all sources will be $79,000. In that case, the extra tax she owes due to the RRSP withdrawal would be $2,820. Remember she saved $3,829, when she put the money in last year, so she is ahead by $1,009, just because of the tax differential.
Time makes RRSPs much better, but the tax savings even year over year can be significant.
The best case scenario is where one’s pre-retirement income is high (providing tax savings at a high rate) and their retirement income is low (causing little tax to be owing on the withdrawals). And indeed, this is often the case. The most common scenario I see is a slight reduction in retirement income relative to pre-retirement resulting in a moderate tax savings.
But even if one is in a higher tax bracket in retirement, RRSPs can be a very good deal. Over time the tax deferral provided by RRSPs is a MASSIVE benefit. This is an often misunderstood and overlooked benefit of RRSPs, one that can dwarf the absolute tax savings achieved by the differential in income. The longer the funds grow without a tax cost, the bigger this benefit becomes, so the earlier you get money into an RRSP the better. And that’s from both a return and a tax savings perspective.
Similarities to TFSAs
By and large RRSPs and TFSAs are vastly different, but there are some commonalities. Similar to TFSA accounts discussed last month, there is a penalty of 1% per month if an over-contribution occurs, although RRSPs have an automatic $2,000 over-contribution allowance.
Another commonality is the ability to name a beneficiary, which can be valuable from an estate planning perspective.
Finally, the list of possible investments that can be held in an RRSP is the same as it is for a TFSA account. But, since RRSPs are most likely to be used for retirement purposes they may lend themselves better to long term investments such as mutual funds.
As alluded to earlier, if you will be in a lower tax bracket in retirement than you are today, RRSPs will almost certainly be the superior choice. If not, they may still be the better choice; it’s just not that clear a decision in that case. Make sure to understand the options or get professional advice if you aren’t sure.
Arnold Machel, CFP® lives, works and worships in the White Rock/South Surrey area.He attends Gracepoint Community Church where he serves on the Leadership Team.He is a Certified Financial Planner with IPC Investment Corporation and Visionvest Financial Planning & Services.Questions and comments can be directed to him at email@example.com or through his website at www.visionvest.ca.Please note that all comments are of a general nature and should not be relied upon as individual advice.The views and opinions expressed in this commentary may not necessarily reflect those of IPC Investment Corporation. While every attempt is made to ensure accuracy, facts and figures are not guaranteed.