Q&A: TFSAs and RRSPs

Question: I imagine you are receiving a tonne of questions regarding the new TFSA (Tax-Free Savings Account) and as an advisor for a major Canadian bank, I’m seeking some objective, outside advice myself.

I was wondering about the potential long-term benefits for someone making a yearly $5,000 contribution into a TFSA as opposed to a RRSP. As far as I can see, the TFSA may be preferable if the investor wasn’t worried about the potential income tax refund, as at the point of withdrawal in, say 20-25 years, they do not have to worry about paying income tax on any withdrawals (as opposed to a RRIF, once the RRSP must be converted), and the income generated wouldn’t claw back any social benefits.

Obviously, this strategy might work better for a lower income earner who can’t afford to make any higher yearly contributions than the $5,000 and wouldn’t really benefit from the tax refund, but what are your thoughts on this? – Greg F.

Gordon Pape answers: As it happens, I have just finished the manuscript for a new book on exactly this subject. It is titled Tax-Free Savings Accounts: A Guide to TFSAs and How They Can Make You Rich and it will be published in early January by Penguin Group Canada.

The book contains a full chapter on TFSAs versus RRSPs, analyzing which plan works better in specific situations. In the case of a lower-income person, the TFSA is definitely the preferred vehicle to use. In fact, the main reason why the C.D. Howe Institute has been championing the concept since 2001 is that RRSPs work against the best interests of modest-income Canadians because of the clawback effect that withdrawals can have on programs such as the Guaranteed Income Supplement and various tax credits.

Although specific cases may differ, I came to three general conclusions after doing a detailed analysis:

1. If the tax rate after retirement is expected to be the same as it is now, TFSAs and RRSPs will produce the same net after-tax result.

2. If the tax rate after retirement is expected to be less than it is now, it is better top up an RRSP before opening a TFSA.

3. If the tax rate after retirement is likely to be higher than it is now, saving in a TFSA will produce a better return than making an RRSP contribution.

Incidentally, copies of the book can be reserved now at http://astore.amazon.ca/buildicaquizm-20

Do you have a money question you’d like to ask Gordon Pape? Please visit this page to find out how. Then check our website every week to see if it was chosen for a response. Sorry, we cannot send personal answers.