TFSA or RRSP? The GIS may change the answer

In my previous article, “TFSA or RRSP? The answer isn’t only about tax rates,” I argued that in the absence of a financial plan, people should contribute to TFSAs.

I based this conclusion on the assumption that most people will not gross-up their RRSP contributions for tax, and the only way that contributing to an RRSP creates more after-tax income in retirement when compared to a TFSA is when the out-of-pocket costs of both are equal.

In my example, Isaac, a 45-year-old single man earning $58,500/year in Ontario, wanted to know the best place to invest the $5,500 he had saved over the past year. He also plans to save this amount each year, indexed for inflation, until he retires at age 65.

We assumed Isaac would receive maximum CPP and OAS, so I calculated that a $5,500 contribution to a TFSA would provide a Maximum Sustainable After-tax Income (MSAI) of $42,500/year ($25,900 in today’s dollars). This was $2,100/year less than the MSAI of $44,600/year ($27,200 in today’s dollars) provided by an RRSP contribution of $7,818 ($5,500 after tax at 29.65%).

Read: TFSA designations may cause estate problems

However, a reader pointed out that I’d neglected to account for the Guaranteed Income Supplement (GIS) in my TFSA analysis.

The GIS provides a monthly non-taxable benefit to low income recipients of OAS. The maximum amount for a single person receiving full OAS is $773.60/month, reducing with each dollar of taxable income earned in the previous year (excluding OAS) to zero at $17,304. In Isaac’s case, if he contributes his $5,500 to a TFSA, his only taxable income will be CPP in retirement, qualifying him for a GIS payment of $174.15/month in today’s dollars.

This meant that instead of receiving $2,100/year less income, when you include GIS, the TFSA provided $900/year more in income or $45,500 ($27,800 in today’s dollars), compared to the RRSP contribution.

Maximum Sustainable After-tax Income at age 65

Contributing the RRSP to a TFSA

Another reader suggested that a TFSA vs. RRSP analysis was not complete unless it also examined the scenario of contributing to an RRSP with the tax refund contributed to a TFSA. But why stop there? We’ll also examine using the tax refund to pay down a mortgage or investing it in further education so the client can get promoted.

Using financial planning software, I ran four new scenarios for Isaac.

• Baseline: $5,500 to TFSA (Isaac applies for GIS)
• $5,500 to RRSP, $1,631 tax refund to TFSA
• $5,500 to RRSP, $1,631 tax refund to Mortgage
• $5,500 to RRSP, $1,631 tax refund to Education

In scenarios 2 to 4, Isaac will not be eligible for GIS payments.

Maximum Sustainable After-tax Income at age 65

Contributing to an RRSP and then contributing the tax refund to a TFSA resulted in $44,100/year ($26,900 in today’s dollars) of income, compared to $45,500/year ($27,800 in today’s dollars) provided by only investing in a TFSA and receiving GIS payments.

For the mortgage example, I assumed Isaac has a $200,000 mortgage that he just renewed at 3.84% for 10 years. It’s amortized over 20 years so that it is paid off at age 65. This means Isaac has a monthly mortgage payment of $1,192.

If Isaac applies his $1,631 tax refund to his mortgage each year, he will reduce his amortization by 39 months (assuming his mortgage allows for annual lump-sum payments and the interest rate does not change in 10 years). If he then contributes the 39 months of mortgage payments along with the final 3 years of tax refunds to his TFSA, this will provide $43,700/year ($26,700 in today’s dollars) — still less than the baseline results.

Read: Plan for the cost of property taxes

In the education example, I assumed Isaac could take work-related educational courses over 3 years for a cost equal to the tax refund, and that once completed he would get a promotion that increases his salary by 5%. Beginning in the 4^th year, Isaac then contributes the tax refund along with the after-tax salary increase provided by the promotion of $2,162 to his TFSA. This scenario provides $46,700/year ($28,500 in today’s dollars), which is $1,200/year more than contributing to a TFSA and collecting GIS.

Bottom line

Without a financial planner’s help and the appropriate financial planning software, few people would be able to do this type of analysis. And, the measured effect of any financial strategy is highly dependent on the assumptions. The best strategy is not the one that provides the highest income or the lowest tax bill, it is the one that the client understands, is willing to implement and achieves his or her income needs.

Dave Faulkner, CLU, CFP, is a financial planner in Alberta and co-founder and CEO of Razor Logic Systems Inc.