TFSA vs. RRSP: How should your client save?

Come January, one of the biggest questions facing financial planners will be “where should your clients put their money — into TFSAs or RRSPs?” There are obvious and not-so-obvious similarities and differences between the two, and this column will evaluate the comparative advantages and disadvantages of TFSAs as well as show how they can be combined effectively to provide your clients with the greatest degree of investment and tax planning flexibility.

TFSAs and RRSPs are directly comparable in four ways: they do not impose a tax on annual investment income; there are penalties of 1% per month for over-contributions; carrying charges are not deductible (because they are not used to earn income in either case); and both require holders to include only eligible investments.

In all other respects, they are quite different financial vehicles, starting with age limitations. While TFSA holders have to be at least 18, there is no minimum age requirement for an RRSP (but with RRSP contribution room based on earned income, it’s hard to imagine minors other than successful child stars qualifying).

As we’ve noted in previous columns, the ability for TFSA holders to carry forward contribution room indefinitely following withdrawals is not replicated with RRSPs. With a few exceptions (notably the Home Buyers’ Plan and Lifelong Learning Plan), when a withdrawal is made from an RRSP, the contribution room it represents is lost forever. Another important difference is the upper age limit. TFSAs can last the holder’s lifetime, but an RRSP matures when the holder reaches age 71, at which time the proceeds are commonly rolled into annuities or Registered Retirement Income Funds (RRIFs).

The differences between the two accounts are more pronounced when it comes to taxes. Unlike TFSAs, RRSPs provide appealing tax deductions for contributions. It is difficult to overlook the instant gratification of the tax deduction from the RRSP contribution. But looking ahead, it helps to remember that, unlike with TFSAs, RRSP withdrawals are taxed as ordinary income, so the holder will not benefit from the reduced rates for capital gains or dividends from Canadian companies. Also, unlike with TFSAs, withdrawals from RRSPs may reduce the holder’s income-tested benefits, including Old Age Security, the Guaranteed Income Supplement and the age credit.

TFSAs appear to have an advantage on the question of contributions from spouses or common-law partners. The taxation for this situation is best explained in the scenario where one spouse earns all the family income. Where the working spouse provides the funds to contribute to a TFSA in the name of the non-working spouse, the income earned in and/or withdrawals from the TFSA are not subject to tax. Therefore attribution rules would not require the working spouse to report any income or gains from the TFSA.

In comparison, with an RRSP, it is unlikely that the non-working spouse would have RRSP contribution room; however, the working spouse could make RRSP contributions to a spousal RRSP. In this case, the working spouse gets the RRSP deduction, but when the funds are withdrawn, the withdrawal is included in the non-working spouse’s taxable income. This is a good income splitting technique (albeit the benefits are somewhat diminished by the new pension splitting rules). However, in certain situations, the attribution rules could apply and require that a withdrawal be included in the working spouse’s income (note that RRSP attribution rules can be complex). I should also point out that, in the first year, this couple could contribute $5,000 each to a TFSA, whereas the RRSP contribution is limited to the working spouse’s RRSP contribution limit.

Both accounts face a deemed disposition on death, but while TFSAs have no tax on the disposition, the fair market value of an RRSP balance will be subject to tax. Both types of accounts allow for transfers to surviving spouses. A transfer of a TFSA to a surviving spouse is on a tax-free basis, whereas a transfer of an RRSP to a surviving spouse is on a tax-deferred basis, since on the death of a surviving RRSP holder, there will be a tax bill on the remaining RRSP balance.

Helping your clients decide

Given the similarities and differences, how do you help your clients choose where to put their money to create the right balance? For most clients, the key choices will be made between TFSAs and RRSPs. Using one or the other, or both, depends on their goals. TFSAs are flexible and can be used to meet either short-term savings objectives or long-term objectives like retirement savings. RRSPs are clearly designed for retirement savings with limited exceptions — allowable tax-free withdrawals (and subsequent repayment) for the Home Buyer’s Plan or the Lifelong Learning Plan.

Your clients’ income levels — now and expected in the future — are also important in choosing between TFSAs and RRSPs. If a client’s marginal tax rate is higher at the time of contribution than it’s likely to be when withdrawals are made (i.e. working income is higher than expected retirement income) an RRSP is preferable for its tax-saving qualities. If the reverse is true, and retirement income (and hence marginal tax rate) is expected to be greater than during the client’s working life, then a TFSA will be the better choice because of those tax-free withdrawals.

For most people, it won’t necessarily be an either/or situation. Those who consistently save and invest throughout their working lives — and there are such people — may well be in higher income brackets at retirement. Over the course of their working lives, they may juggle the utility of both types of accounts. RRSPs can be used to build savings that will generate retirement income (but hopefully not so much that OAS/GIS and age credit benefits are depleted) while TFSAs can be used to top up savings.

Along the way, you need to help your clients juggle the need to contribute to savings while paying off their mortgages, a debate that gains a new layer of complexity with the arrival of TFSAs. Previously, the debate focused on the pros and cons between contributing to an RRSP (gaining a tax deduction and a deferment) and paying down the mortgage on an asset that can generate a tax-free profit. The decision depended on many factors, including the mortgage rate, the expected rate of return on the RRSP investment and the tax rate on the RRSP deduction. Now, TFSAs add a third choice to the debate. Like mortgage repayments, TFSA contributions are in after-tax dollars, and investment gains will not be taxed. In choosing between the two, you have to estimate the future cost of mortgage rates and the possible investment return on the TFSA. Many of your clients will take the middle ground, continuing to contribute to their RRSPs and then using the tax refunds to both reduce mortgages and build TFSA savings.

It sounds complicated, but it isn’t. The important thing to remember is that the TFSA is another weapon in your clients’ savings arsenal. And depending on their circumstances, it can be used alone or in concert with other savings and investment vehicles to save tax and leave more money in their hands.

Michelle Munro

Tax & Estate

Michelle Munro is director, tax planning, for Fidelity Investments Canada ULC.