Since the introduction of the Tax Free Savings Account (TFSA) for Canadians in 2009, there has been a debate over which savings vehicle is best. Although there are several factors which come into play such as income, marginal tax rates, clawbacks on retirement benefits, and utilization of the RRSP Home Buyer’s Plan, in this article I’m going to put a less mathematical spin on it all. Everyone has a unique situation, but I’ll help you skip to the simple conclusion.
The TFSA vs. RRSP Debate in a Nutshell
To start, there are 2 situations where the TFSA is the obvious choice:
- You have no RRSP contribution room remaining
- You want to have easy access to your savings
The real debate is for anyone not maxing out RRSP contributions, but wanting to save for the long-term. Making an RRSP contribution will get you a tax break today but will be taxed as income when you draw on those funds during retirement. To fund your TFSA, you’ll be using after-tax dollars but they won’t be taxed when you withdraw them down the road.
The bottom line here is that the TFSA wins if your current marginal tax rate is lower than your anticipated marginal tax rate when you would draw from your RRSP in retirement.
Betting on Yourself
What do savings contributions and marginal tax rates have to do with betting on yourself? Simple, do you think you’ll do well enough financially for your marginal tax rate to be higher in retirement than it is today? Are you going to place your wager on a higher or lower marginal tax rate in your retirement years?
If you plan to work as an employee until age 65 and then retire off on your pension income and savings, your marginal tax rate is likely to be lower in retirement than it is now (unless your portfolio does tremendously well).
On the otherhand, if you currently working to build streams of passive income through businesses or real estate investments, then some of your income may persist into your retirment years, and your marginal tax rate may be higher than it is today. In this case, the TFSA will be your winning strategy.
Beware the Trend
Regardless of what you estimate your future income will be, the rates for each tax bracket are likely to be higher in the future. Given the nature of our pension system and demographic trends, tax cuts seem unlikely over the longhaul.
Simply consider the number of people currently working today compared with the number of retirees today. The current ratio of income earners to retirees allows our social security program to work well, but this ratio will be changing soon. As the boomers enter retirement, there will be more retirees and fewer income earners (taxpayers) to pay for the retirement benefits of the boomer generation. When the government needs to cover the benefits they’ve promised our aging population, tax cuts are out of the question.
The sustainability of social security is questionable, so be sure you save enough during your working years to fully fund your own retirement. For most, that means socking away more than the $5,000 per year we’re allowed to contribute to our TFSA accounts to make sure your “Golden Years” are truly golden. To make the most of your savings strategy, consider a Self-Directed TFSA which opens up more investment options compared with Savings or Mutual Fund TFSAs.
Most importantly, if you’re not yet betting on your marginal tax rate being higher during retirement, figure out a way to make it happen!
photo credit: banspy
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