Do TFSAs and RRSPs really compete? And who wins?

Many individual TFSAs had a spectacular first year. Even invested in high-quality stocks or trust units, many grew by as much as 60 per cent, thanks to the great timing of the market bottom in March 2009. One account of which I am aware soared by 130 per cent, to $11,500 by the end of the year.

None of that will happen again this year, I expect, and that is not the point. RRSP contributions made into those same investments at the same time grew by the same amount.

Instead, we are here to say happy birthday, then focus on how the TFSA and the RRSP might best coexist.

If you have personal non-registered money that is earning taxable investment income, then moving that money into a TFSA is a no-brainer. This account shelters the investment income from tax, with no significant strings attached. (If you don't have cash around, then it is not an obvious thing to do.) However, it does not provide a tax deduction on contribution.

Unlike the RRSP, there is no tax on the TFSA withdrawal, either of original invested capital or investment earnings and growth. Therefore, there is no risk either from early collapse, or from using your future large TFSA as a source of retirement income.

The future withdrawals will not increase your tax bill or negatively affect other government programs, like tax credits or Old Age Security.

So should I consider a TFSA instead of an RRSP contribution, if I have limited money to invest for retirement? The reality is that many people struggle to maximize their RRSP, and do not have spare cash to fund a TFSA.

Using the TFSA to put your retirement investments means giving up the immediate tax refund that can be created by contributing the same amount to an RRSP. A fair comparison, therefore, must assume that you use that tax refund to add to your investment capacity right now, meaning that using an RRSP increases your savings capacity by as much as 46 per cent, depending on your marginal tax rate.

Does that mean that the RRSP will work much better for retirement? Surely, if you can put away 40 per cent more money now and have that grow and compound for 20 or 30 years, that nest egg will be much larger.

Well, let's look at an example, using $5,000. (If you can afford to contribute more than that, then use the RRSP for the excess.) We will use a 35 per cent marginal tax rate today, and a 28 per cent marginal tax rate in retirement.

A $5,000 RRSP contribution and tax deduction saves $1,750 in immediate taxes. If you add these together, then $6,750 can go into the RRSP this year, compared to $5,000 into the TFSA.

If you do each for 30 years and earn seven per cent (by investing in good quality equities), my old HP 12C calculator tells me the TFSA grows to about $434,000 and the RRSP to about to $586,000. As expected, advantage RRSP, but here is where it gets fun.

Let's assume we withdraw five per cent in retirement, or $21,700 from the TFSA and $29,300 from the RRSP. You keep the $21,700, as it is not taxable.

On the RRSP income, you must pay 28 per cent tax, or $8,204, leaving you $21,096 to spend. Advantage, TFSA.

The RRSP income is likely to cause the loss or reduction of income-tested tax credits, which means an effective 25 per cent penalty. To the extent that your income is above $66,733 after age 65, then you will also lose $3 of OAS for each $1 of taxable income.

Have your tax professional prepare an analysis based on your current tax bracket and estimated income in retirement. Each situation is unique.

I give the TFSA more respect as a one-year-old than I did when it was a newborn. Adding to that is our continuous tax planning with retirees, where we work hard each year to prepare income plans that minimize taxes, maximize credits and avoid OAS clawback, while still trying to use the assets in their RRSPs.

It is a continuous challenge, but I guess that's why we get paid! The TFSA gives us another weapon, one to which we are paying close attention.

David Christianson is a fee-for-service financial planner and portfolio manager, whose team at Wellington West Total Wealth Management Inc. provides comprehensive financial advice and management. You can e-mail him at dchristianson@wellwest.ca or visit his blog at www.davidchristianson.com.

Republished from the Winnipeg Free Press print edition February 5, 2010 B14