Don't be blinded by the tax return

National Post

2011-01-15


In researching my recent report on TFSAs vs. RRSPs, I was intrigued by how preoccupied some investors are with getting that nice refund cheque each spring as a result of proudly socking away as much money as they can into RRSPs. But this blinding obsession with the instant gratification granted by the tax refund may cause some Canadians to steer clear of TFSAs altogether, when they should perhaps be diverting some of their retirement savings into this newer tax-free vehicle.

Let’s take a closer look at this refund. Where does it come from and what does it represent?

RRSP contributions are made from pre-tax income. This means that if you choose to set aside some of your current income for consumption later on, by contributing it to an RRSP, you can avoid paying tax currently on that income and defer it until the funds are later withdrawn, presumably upon retirement.

Contributions to a TFSA, on the other hand, are from after-tax funds and therefore are not tax deductible from income and do not result in a refund come tax season. The big advantage, however, is that not only are income and gains on investments held within a TFSA not taxed annually while inside the TFSA, but they can be subsequently withdrawn tax-free.

Canadians who can afford to maximize both RRSP contributions as well as make their annual $5,000 TFSA contribution would generally be well-advised to do both. But the reality is that most Canadians simply don’t have enough available cash annually to afford to contribute the maximum to both plans and as a result, must make an important decision, namely, which savings vehicle should take priority: the RRSP or the TFSA?

Conventional thinking seems to have steered most Canadians towards the tried and trusted plan, the RRSP, at the expense of the TFSA. The fact is that with the same rate of return assumption, the same compounding period and constant tax rates at the date of contribution and the date of ultimate withdrawal, the amount of after-tax cash that can be accumulated in an RRSP or TFSA is identical.

Where TFSAs can play a more prominent role is when your expected marginal effective tax rate upon withdrawal will be higher than it was when you contributed. This can be the case for younger Canadians, who are currently in low tax brackets but aspire to reach a higher bracket throughout their working careers and ultimately in retirement.

It can also be the case for retirees who face the loss of government benefits, such as OAS, when forced RRIF withdrawals put them into a higher marginal effective tax rate and who would have been better off maximizing TFSAs, whose withdrawals don’t negatively impact government benefits.

But what concerns many a prospective TFSA contributor is that if you make a contribution to your TFSA by forgoing a contribution that otherwise would have gone into an RRSP, you won’t get as a large a tax refund.

The refund associated with an RRSP contribution should not be considered a windfall but rather the present value of the future tax payment that will have to be made on the ultimate RRSP withdrawal (assuming tax rates are constant). In other words, the tax unpaid on the funds contributed to an RRSP is merely being deferred to a later point in time when the funds are ultimately withdrawn and taxed, either through an RRSP or RRIF withdrawal.

Some have suggested that you put your tax refund into your TFSA, presumably to get the best of both worlds. But what are you really doing?

Assuming your TFSA grows at the same rate of return as your RRSP, then the fair market value of your TFSA will equal your future tax payable on your RRSP withdrawal. So spending the refund now is the equivalent of borrowing money against your future income at a rate of interest equal to the expected rate of return on your RRSP!

While the average Canadian is unlikely to able to determine, with any certainty whatsoever, whether to maximize his TFSA or RRSP, perhaps with some financial guidance and a better understanding of how these new savings vehicles work, TFSAs may become the retirement vehicle of choice for many more Canadians going forward.