It’s Registered Retirement Savings Plan (RRSP) season and the question most likely on your mind is: should I invest in RRSPs or should I invest in a Tax Free Savings Account (TFSA)?
Often these kinds of questions get answered from the perspective of someone earning lots of money, but this column looks at the question from the perspective of Fred, an average worker who earned about $44,000 last year.
The nice thing about RRSPs and TFSAs is that they allow you to earn income and get preferential tax treatment. With an RRSP contribution, you get an immediate tax deduction. The money earned in the RRSP is not taxed, but when you take any money out of the RRSP (including investment returns), you pay tax on it. With a TFSA, you get no tax deduction but all income earned inside the TFSA is tax exempt and when you take the money out of the TFSA it does not count as taxable income. Given these differences, we need to consider which is better for Fred.
Fred can mix and match with RRSPs and TFSAs, but we will just look at two options:
1) Putting all his money in a TFSA or
2) putting it all in an RRSP.
Once you read through this, you will understand what Fred and all those Canadians like him need to consider while planning for their retirement. I started by assuming that Fred does not have a defined benefit or a target benefit pension plan – because most private sector employees don’t. That assumption is crucial.
Let’s imagine that Fred is able to save about $2,320 during the year. He can put that in either his RRSP or his TFSA. If he puts it in his RRSP, he could use the income tax savings to top up his RRSP contribution to $3,000. So his options are:
1) Put $2,320 in a TFSA or
2) put $3,000 in an RRSP.
Both options leave the same amount of disposable income after Fred pays his income tax.
If Fred puts $3,000 into his RRSP each year for his entire career and he earns an average of 7 per cent on his RRSPs, after a 40 year career Fred will have around $600,000 in his RRSP. He can then convert that to a lifetime income stream which pays him about $39,000 per year. Fred will also get around $11,000 from the Canada Pension Plan (CPP) and around $6,800 from the federal government for Old Age Security (OAS). He will have to pay approximately $10,600 in income tax. Fred will not be eligible for the federal government’s Guaranteed Income Supplement (GIS) because his taxable income is too high. In retirement, his net income would be about $46,200.
Sounds like a great plan – but it’s not. Under the current tax regime, if instead of putting $3,000 per year into RRSPs, Fred puts $2,320 into his TFSA every year and again earns an average of 7 per cent, after a 40 year career, Fred will have around $460,000 in his TFSA. That would produce a tax free income of about $30,000 per year. He would also earn $11,000 in CPP and $6,800 in Old Age Security (OAS). His income tax would be around $1,200, and as a result he would have an after tax income of $46,600 – which is slightly better than having used RRSPs.
But wait – there’s more. Because Fred’s taxable income is so low, he would get an additional $3,500 in GIS from the taxpayer so his actual after tax income is over $50,000.
Like Fred, most private sector employees are middle-income workers without a defined or target benefit pension plan. A TFSA is much better for them because it allows them to save for retirement and still collect a GIS benefit paid by future taxpayers.
Workers who are part of a defined or target benefit pension plan don’t get to make this choice. According to Statistics Canada, about 85 per cent of public sector workers and about 12 per cent of private sector workers are in a defined or target benefit pension plan. They are forced to save money for their retirement in a way that saves the future taxpayers a significant amount of money. Perhaps that is why such plans are so popular in the public sector – they are fair to future taxpayers.
Dominique Roelants is the Executive Officer of the B.C. Teachers’ Pension Plan.