RRSP plans in a post TFSA world

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Some clients may be coming up short for RRSP top-ups this spring, having maxed out their TFSA contributions early in the New Year. And who can blame them? Clients are bombarded by advertisements touting the benefits of the TFSA.

More often than not, the TFSA marketing message has come from the banks. Intent on gathering assets, these campaigns do not always fit best with the investor’s goals. High interest savings accounts may be good for building an emergency fund, but gains are too small to require the tax-sheltering benefits of the TFSA.

“At 2% or 3%, $5,000 is going to earn $150. That’s a grand total of $69.60 of tax saved annually, $5.80 a month,” says Warren Baldwin, regional vice-president at TE Wealth Financial Consultants. “Why did we even get out of bed this morning? It’s just ridiculous.”

On the other hand, Baldwin and others like him are using the TFSA in ways that do make a lot of sense. “If you put $5,000 into certain funds last January, you now have about $5,700.”

For the more daring investor, the TFSA can be used to generate funding for the RRSP. While $5,000 is a relatively small amount in a long-term financial plan, the tax-sheltered status may tempt investors to swing for the fences.

Although at this point a lot of the low-hanging fruit appears to have been picked, home run strategies where clients invest in obviously undervalued assets, appear to be an excellent way to make use of tax-free investment accounts.

An investor who invested $5,000 while markets bumped along the bottom may now find themselves with a healthy gain: 20% would give them a balance of $6,000, and some advisors report having clients with as much as $13,000 in their accounts which can now be withdrawn without paying capital gains tax. What’s more, because they’ve done well, this room created by their gains will continue to be available to them in the future.

A word of caution when moving money around, however: Gains are carried forward, but withdrawing cash, then re-contributing in the same year could result in steep over-contribution penalties.

Knowing how to use the TFSA alongside the RRSP is where the advisor shows their value. If a client has sufficient cash flow, the TFSA need not cannibalize the RRSP.

“I told one client, we need $5,000 for your TFSA,” says Murray Morton, branch manager in the wealth management division at Dundee Securities. “He asked if we could take it from his cash account. I said ‘no, just give it to me from your bank account.’ He laughed and wrote me a cheque.”

Sometimes it takes a common sense approach and a little bit of advice to help clients navigate the relatively new accounts in a sensible way to avoid cannibalizing a financial plan’s registered savings components.

For low income earners too, the TFSA can be a more efficient and economical way to save money for future goals. For those already paying the lowest marginal income tax rates who will likely be paying higher rates of tax in the future, the TFSA puts a new twist on savings plan options.

In retirement, withdrawals from a TFSA will not trigger a clawback of income-tested benefits such as Old Age Security payments. And these withdrawals are made tax-free, unlike withdrawals from a RRIF.

The RRSP has built in obstacles, withholding tax and the destruction of contribution room, to deter clients from raiding it for short-term needs. There are access points, of course, such as the Home Buyers Plan, but these withdrawals entail a 15-year repayment schedule.

Many younger investors have tapped their RRSP to buy their first home, and found themselves making repayments without the incentive of a tax credit. For a client who plans to buy a house in the near future, the TFSA may make more sense.

It has relatively few barriers to access, but assuming clients are disciplined enough to keep saving, money from a TFSA can be used for home purchases – the savings are free and clear, without the 15-year repayment schedule.

Subsequent RRSP contributions will continue to generate their usual tax credits, and the money pulled out of the TFSA may be redeposited into the account, eventually.

For younger clients in a lower income tax bracket, opting for the TFSA makes sense for the longer term as well. If they contribute to their RRSP, not only will they will use up a portion of their contribution room, but the tax credit they generate will be of little value.

This contribution room can be taken advantage of in the future, hopefully when the client is earning more and paying higher income taxes.

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• Kate McCaffery is a Toronto-based freelance financial journalist.

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