Tag: RRSP/RRIF

RRSP over TFSA as default choice – Analyzing marginal & average tax rates

Published version: Linkedin

There’s a scene in Doc Hollywood where Michael J. Fox, the fresh med school grad, is readying to airlift a young patient out of the small town for emergency heart surgery. Just before liftoff, the aging local doctor shows up and hands the boy a can of pop – Sip, burp, everybody go home.

Theatrics aside, there’s a lesson here for the RRSP vs. TFSA debate.

Since its introduction in 2009, the TFSA has proven to be a powerful tool that opens up countless possibilities for bettering our financial lives. However, when it comes to retirement savings, the tried-and-true RRSP should be the default choice for most of the population. Here’s why.

Tax treatment IN, tax treatment OUT

Both RRSP and TFSA give you tax-sheltered income and growth on the investments within them. The key difference is what happens on front and back end:

  • RRSP deposits are pre-tax, while withdrawals are taxable;
  • TFSA deposits are post-tax, but withdrawals are non-taxable.

Of course, it’s often said that RRSP contributions are tax-deductible, the appeal being the desired refund. However, to convert that to being truly “pre-tax”, all such refunds (and refunds on refunds) must in turn go into RRSPs. That’s already handled through reduced withholding tax on a work-based group RRSP, but with an individual RRSP that’s your own ongoing responsibility.

Base comparison

If your income is taxed at the same rate when contributing and withdrawing, you will net the same amount of spendable cash whether you use the RRSP or TFSA. Using $100 at a 40% rate and a 10% one-year return (for simplicity, not reality), here is what each yields:

  • RRSP  $100 deposit + $10 return = $110 taxable, netting $66 spendable
  • TFSA $60 deposit + $6 return = $66 spendable

If you are at a higher tax rate going in than out, the RRSP will do better, and vice versa. If you change the example to 40% in and 30% out, the RRSP nets you $77, but the TFSA is still $66. And if your later rate is instead 50%, RRSP nets $55, and once again TFSA $66.

Is it really that simple?

“Same rate” – Marginal or average?

Having made the point about taking care in managing the deductibility of an RRSP contribution, we can’t lose sight that it is indeed a deduction. The benefit is that your RRSP contribution comes off the top at your marginal rate, saving you tax at the highest rate you would otherwise face.

On withdrawal in your later/retirement years, the appropriate measurement is arguably (I’ll come back to this) your average tax rate. Average tax rate is total tax divided by total income. In a progressive tax system where there is more than one bracket, average rate will always be lower than marginal rate.

That in mind, imagine for a moment that there were no contribution limits for either plan type. Even if you were at the same (indexed over time) income level in retirement, the RRSP route would do better than TFSA, because the average rate out must be less than the marginal rate in.

But what’s your own average rate?

In truth, not all your retirement income will come from RRSP savings alone, which brings me back to the arguable point about whether to use the average tax rate as stated above.

Once you begin your CPP and OAS, you have no further discretion whether or not they are paid from year to year. That then forms your foundation lower bracket income, on top of which your RRSP (in the form of a RRIF or annuity draw) is layered. In that case, the applicable average rate should be calculated on the income above this non-discretionary floor. Still, as long as there are at least two brackets, and you were the higher on contribution,  this modified average rate will be below your original marginal rate.

It gets more complicated if the OAS clawback comes into play, adding about 10% net to the marginal effective tax rate (METR). But even if you were entitled to maximum CPP and OAS of about $20K, you’d be progressing up through low to mid brackets until you hit the OAS clawback as you neared $80K. Nonetheless, according to my calculations, average rate would still be materially below marginal rate at full clawback around $130K.

Default choice, not dogmatic requirement

To repeat, the point here is that RRSP is the default choice, but that it could be displaced based on other factors.

Factors that bolster RRSP include: the fact that most people live on a lower income in retirement, meaning both lower marginal and average rates; spouses using pension income splitting to bring down their combined average tax rate; and, the availability of the pension credit.

Comparatively, the TFSA may be favoured when: an income earner is at low bracket at saving age; there are already significant RRSP assets; or, a large inheritance/winfall has arisen that affects the timing and/or amount of required drawdown from existing savings.

It’s the financial advisor’s job to identify these and other relevant factors, assess the effect of each, and discuss with their client how to maneuver with that knowledge. In reality, it’s more about proportionality than a binary RRSP vs. TFSA decision. Having an appreciation for the technical underpinning will make for better-informed choices and greater confidence to stay the course.

5undamentals – RRSP – Registered Retirement Saving Plan

Published version: Linkedin

1. Nature of an RRSP

Purpose – The RRSP is designed to assist with long-term savings, generally funding toward your retirement years. Being ‘registered’ with the Canada Revenue Agency (CRA), it is entitled to beneficial tax treatment, while having to comply with stringent rules governing its ongoing use and operation. As the owner of the RRSP, you are known as the annuitant.

Investment options – Qualified investments for RRSPs include money accounts, deposits with a regulated financial institution and guaranteed investment certificates; stocks, bonds and most other securities listed on a designated stock exchange; and mutual funds and segregated funds.

Key tax features – Contributions to an RRSP are deductible in calculating current income. Income and growth within the RRSP are not taxed. Withdrawals are taxable in the year taken. This defers tax and facilitates lower ultimate tax if the annuitant is at a lower tax rate in future.

2. Funding your RRSP

Contribution limits – A person is entitled to annual contribution room equal to 18% of the previous year’s earned income, limited to an annually indexed dollar maximum. For your 2019 tax return, the dollar limit is 18% of 2018 income, to a maximum of $26,500, which would be reached at income of $147,222.

Spousal plan – If you have a spouse or common law partner (CLP), you may contribute to a spousal RRSP. You will get a current deduction, and the eventual withdrawal will be taxable to your spouse/CLP. However, if a withdrawal is made the same year or the next two years, the income will be attributed to you. Otherwise this can be an effective income splitting strategy.

Timelines – In order to claim the deduction, generally a contribution must be made in the calendar year, or within 60 days of the year-end. To qualify for deduction against 2019 income, the contribution deadline is Monday March 2, 2020.

Unused room – If you do not make a contribution, your unused room is carried forward for you to use in future years. In fact, even if you make a contribution, you can either claim the deduction in that year or carry the deduction forward to claim against income in a future year.

Over-contribution penalty tax – Contributions in excess of a person’s available room are subject to a tax of 1% per month that the excess remains in the RRSP. A lifetime $2,000 over-contribution amount provides relief for inadvertent over-contributions, but there is no deduction allowed when this happens, and if it is deliberate then the penalty tax will still apply.

3. Access before retirement, without triggering tax

Generally – A withdrawal from an RRSP is normally taxable in the year taken. There are two programs that allow non-taxable withdrawals, so long as funds are repaid to the RRSP according to regulated timelines. If repayment is not made, the unrepaid amount is taxable, and no RRSP room is recovered.

Home Buyer’s Plan (HBP) – Qualified first-time homebuyers may each take up to $35,000 to be used toward a home purchase. You must buy or build before October 1st of the year after the year of the withdrawal. Repayment may be spread across 15 years, beginning 2 years after the withdrawal year.

Lifelong Learning Plan (LLP) – You can withdraw up to $$10,000 per year to a maximum of $20,000. Funds must go toward full-time training or education for you or spouse/CLP. Detailed rules determine when you cease to be a student, following which you have 10 years to repay the withdrawal.

4. Taking funds from your RRSP

Cash withdrawal – When you withdraw money from your RRSP, the amount taken is taxable to you in that year. Your RRSP administrator will withhold a percentage for taxes and remit that to CRA: 10% on amounts up to $5,000, 20% from there to $15,000, and 30% on amounts over $15,000.

Tax-free transfers – At any age you may make a tax-free transfer to an annuity or registered retirement investment fund (RRIF). An annuity pays a guaranteed fixed amount for life or a set number of years. A RRIF can be invested like an RRSP, but has a mandatory minimum annual percentage withdrawal. RRIF payments are taxable income, but there is no withholding tax on RRIF minimum payments.

Mandatory maturity – No further contributions may be made after December 31 of the year that the annuitant turns 71. No later than that same December 31 year-end, an RRSP must be matured by one or more of the combination of cash, annuity or RRIF.

Spousal transfers – If your relationship with your spouse/CLP ends, an RRSP may be transferred between you without tax applying. It continues to be an RRSP in the recipient’s hands, subject to tax on eventual withdrawal.

5. Procedure and options on death

Income inclusion – On death, the full amount in the RRSP is treated as taxable income. It is added to all other income earned in the annuitant’s terminal year, which is January 1st to the date of death. This income inclusion applies even if the RRSP assets are directed to a named beneficiary.

Named beneficiary – An annuitant can name a beneficiary to receive the RRSP; otherwise the RRSP administrator will pay the plan proceeds to the estate of the deceased. In the estate, the RRSP assets will be distributed in accordance with the deceased’s Will, or by the rules of intestacy if there is no Will.

Tax-free rollovers – If the named beneficiary is a spouse/CLP, there may be a tax-free rollover to the RRSP of that person. If the RRSP was paid to the estate, there may also be a rollover to a spouse/CLP who has a sufficient financial entitlement as an estate beneficiary. Rollover may also be available to a disabled financially dependent child or grandchild. Limited rollover may be possible if that child is not disabled.

Magic Number – What are some advisor assumptions on how much to save?

How much do I need to save for retirement? It’s the most common question asked of financial planners.

Of course, the response depends on how much you’ve already set aside, how much you need to live on now, and how much you want to (or must) spend in those later years. That’s the core of financial planning, and there’s a lot of information to be gathered, decisions and assumptions to be made, and calculations to be applied to come up with viable options and sound recommendations — and even then, there is still some degree of uncertainty.

This doesn’t mean that you don’t go to the effort, particularly if you are the financial planner tasked to make those recommendations. The critical step of any plan though, is putting it in motion.

Heuristics – The appeal of simplicity

In the face of what may feel like a laborious and elusive task, people often prefer to use a heuristic, for example “save 10 per cent of your income.” This is also known as the 10 per cent rule. Because it is so simple, it may very well get things moving, which in fairness, is a victory in itself.

Once good saving habits are established and experience gained, adjustments can be made that cater to changing circumstances.

Even so, 10 per cent is just a nice, round, but otherwise arbitrary figure. The aura that surrounds it should not be confused with the principled due diligence that informs good financial planning.

Do you apply it before or after…?

If we’re not careful, the apparent simplicity can be misleading. How you apply it is equally and arguably more important than the rate you choose in the first place. Too little and there’s not enough when you need it. Too much and the budget stress could be overwhelming, perhaps leading you to abandon the initiative you have taken. Consider these key tax issues:

Is the 10 per cent set before or after income tax?

In other words, are you applying it to gross income or net income? As a rough example (which varies by province), the average tax rate at $100,000 is about 25 per cent.

So, do you target $10,000 based on the gross, or about $7,500 based on the net? That could hinge on the mechanics of how you save.

If you pre-calculated $10,000 then you could pre-authorize a proportionate dollar amount from each paycheque/auto-deposit.

If instead you took 10 per cent off each deposit after it is in your account, it would come out to $7,500.

Are you saving with before-tax or after-tax dollars?

As compared to the first question, which was about the amount to save, this is about deductibility. Put in more familiar terms, you could make a deductible RRSP contribution, or a non-deductible TFSA deposit.

While you can get more into the RRSP to begin, eventually that is taxed on withdrawal before you can spend. TFSAs face no further tax. You’ll need to look at tax rates now (known) and in retirement (assumed) to properly compare. If you’re doing some of each, the arithmetic is more challenging.

Pre- or post-payroll?

If you contribute to a workplace group RRSP, your employer will generally reduce its withholding tax, as it knows of this deduction. When you contribute to your own RRSP, the annual withholding will likely exceed your actual tax due, resulting in you receiving a tax refund. While you don’t have to, reinvesting the refund effectively boosts your savings rate.

Canada Pension Plan?

The CPP is a savings program, with a base premium of 4.95 per cent. It is withheld by your employer, so most people wouldn’t notice or think of it as saving, per se. But depending on your response on the preceding questions, it could be quietly baked into your savings rate. And with premiums increasing to 5.95 per cent over the next few years, and an additional four per cent premium on higher income levels after that, it warrants a closer look to make sure it dovetails with your intentions.

Housing and mortgage?

What does housing have to do with it? Well, equity in a house is a type of saving, usually by first saving a down payment then servicing a mortgage. As an owner, you defray some of your future shelter costs, whereas otherwise you would need more savings to pay future rent. Whether this is before, after, or part of your 10 per cent depends on your circumstances, which is why a holistic financial plan should underlie your efforts.