For some Canadians, tax-free savings accounts (TFSAs) — not Registered Retirement Savings Plans (RRSPs) — may be the best vehicle for saving for retirement, finds a new report from CIBC's tax and estate planning expert, Jamie Golombek.
However, a lack of understanding and appreciation of how TFSAs work has many Canadians missing out on the benefits of this powerful new retirement savings tool. Since its launch in 2009, only 20 per cent of eligible Canadians have opened an account investing some $19 billion tax-free.
In his report entitled, Blinded by the "Refund": Why TFSAs may beat RRSPs as a better retirement savings vehicle for some Canadians, Golombek attributes this partly to the newness of TFSAs. But he also thinks that a broad misunderstanding of the RRSP "refund" combined with an unfamiliarity of the tax mechanics behind both RRSP and TFSA contributions and withdrawals may explain the modest uptake of the TFSA by investors.
"Unlike an RRSP, on which tax is paid when the funds are withdrawn, assets held within a TFSA are "tax pre-paid" as the tax has already been paid in advance," said Golombek. "While investors who can afford to maximize their contributions to both a TFSA and an RRSP would be wise to do so, many investors who cannot are so focused on receiving the tax refund associated with RRSP contributions that they may be missing out on the longer-term advantages of the TFSA."
The CIBC report shows that given identical tax circumstances, compounding periods and dates of contribution and withdrawal, the amount of after-tax cash that can be accumulated within an RRSP or TFSA is identical.
"Where the two plans differ greatly is on the matter of accessibility," notes Mr. Golombek. "The TFSA offers greater flexibility as contributed funds can be withdrawn at any time tax-free and later re-contributed, while RRSP withdrawals are taxable within the same year and cannot be re-contributed.”
Canadians are accessing funds in their RRSPs pre-retirement at an alarming rate, said Golombek. Recent data shows that of the 1.9 million Canadians who withdrew $9.3 billion from their RRSPs in 2008 (the most recent year for which statistics are available), over 80 per cent of such withdrawals were made by individuals below age 60, he said.
Not only can these RRSP funds not be replaced at a later date, the tax paid on these funds can push an individual into a higher tax bracket, and could reduce his or her income-tested benefits, including the GST/HST Credit, the Canada Child Tax Benefit and the Working Income Tax Benefit.
TFSA withdrawals, on the other hand, avoid both these problems since the funds can be recontributed at any time following the year of withdrawal and the withdrawals, being non-taxable, cannot trigger the loss of government benefits.
Investing in a TFSA may also be preferable for many lower-income Canadians whose marginal effective tax rate at retirement is expected to be higher than their rate while they are working. The rate takes into account not only statutory income tax rates but also the effect of income-tested government benefits and credits which are reduced based on net income.
"Seniors currently living on RRSP or Registered Retirement Income Fund withdrawals find that even modest withdrawals from these plans upon retirement affect the retiree's eligibility for income-tested government benefits and credits, such as the Guaranteed Income Supplement (GIS), Old Age Security (OAS) benefits and the age credit," said Golombek. "Since withdrawals from a TFSA are not considered to be "income," they have no impact on the amount of GIS or OAS received nor will such withdrawals reduce the age credit."
Given the many variables affecting the benefits of both retirement savings vehicles,
suggests that all Canadians sit down with a financial advisor to assess the best way of saving that meets their needs.