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TFSA or RRSP contribution? It depends on you!

In previous articles I have discussed Mr. Money’s favourite investment rule for increasing net worth: the Rule of 72, which provides an indication of the number of years that it takes a sum invested to double.

For example, a thousand dollars invested today at five per cent would double in value in just over 14 years.

Of course what this rule does not fully demonstrate is the true negative impact of income taxes on your ability to reach your stated financial goals.

If you invest a thousand dollars in a taxable investment, and are in the 32 per cent marginal tax bracket, you would earn an after-tax return of 3.4 per cent, and your investment would need an additional seven years to double.

Given this sobering fact, many ask what is a better strategy — a tax-free savings account (TFSA) or a registered retirement savings plan (RRSP) deposit?

It depends on a number of factors: what you expect your retirement income will be, and by extension, the tax rate in retirement; whether you expect your income to be subject to the old age supplement (OAS) claw back of 15 per cent; and how much you owe in personal debt.

As a general rule, the taxman treats all withdrawals from a TFSA as tax free, and thus not included in income, in determining the OAS clawback.

In contrast, RRSP contributions provide a tax deduction, reducing taxes owing, and providing ongoing tax-deferred savings in your working years. However, all registered retirement income fund (RRIF) withdrawals made while collecting OAS are added to income in testing whether you are subject to the OAS clawback. If your income is greater than $69,562, as of 2013, at least a portion of OAS payments will be clawed back.

Another example will help us to better understand these rules. Assume that your post-retirement income will be greater than $69,562 — the OAS clawback threshold. A TFSA withdrawal of $10,000 would not be subject to income taxes, nor would it be included in income when determining any impact on your OAS benefits.

In contrast, $10,000 in RRIF payments would be fully subject to taxes, and included in income to determine the OAS clawback. After taxes, you would have $6,400 in cash flow. However, factoring in for the OAS clawback, your net RRIF income would be reduced by an additional $960.

If your post-retirement income is less than the OAS threshold, say $40,000, your marginal tax rate would be 25 per cent. Once again, a $10,000 TFSA withdrawal would be tax-free. Moreover, given that your income is lower than the OAS clawback threshold, this withdrawal would not be subject to additional taxation, such as the clawback.

So which is better — an RRSP or a TFSA contribution? It depends on the time frame you are considering and your overall personal situation.

If you expect post-retirement income to be over the OAS clawback threshold, a TFSA contribution is potentially better. If you expect post-retirement income to be lower than the OAS clawback threshold, an RRSP contribution is potentially better.

However, this does not give many of us immediate comfort, especially if our retirement is many years away. So perhaps a better short- to medium-term strategy is to maximize current household cash flows.

In other words, maximize RRSP contributions that either reduce taxes paid today or even provide a cash inflow in the form of a tax refund.

A $5,000 RRSP contribution today could potentially provide a household in the 32 per cent tax bracket a $1,600 tax refund, which could be used to make a TFSA contribution — diversifying sources of post-retirement income between RRSPs and TFSAs. This would give you flexibility in the future.

If you have a credit card or other unsecured debts, using the refund to pay down debts would increase your net worth immediately, and save you money in the form of reduced interest expense.

The refund, used to pay down a credit card debt priced at 19.9 per cent would be a significant tax-free return on investment. Where else can you earn 19.9 per cent?

In the final analysis, it is your choice whether you make an RRSP or a TFSA contribution. Both have short- and long-term benefits that help you maintain control of your financial destiny.



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