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Which tax-friendly savings tool will walk away the champion?

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It's a retirement savings title fight -- pitting one account against the other.

In one corner, the long-reigning champion of retirement savings: the RRSP. Known for its instantly gratifying tax refunds, its savings punch can put more money in your wallet today and help you pay less tax in retirement.

In the other corner, we have the challenger: the TFSA. Relatively new to the blood sport of retirement savings, it's easy to underestimate its agility, able to dodge the taxman's jabs to your income both in the short and long run.

Since its inception, pundits have pontificated about whether this up-and-comer has what it takes to supplant the champ as the true king of retirement savings strategies.

Here we put them head to head in a battle to find out just who the real savings champion is.

But before the fight begins, let's talk rules.

Everyone's savings situation is different. One strategy might work for you and another might not.

These are two well-matched fighters, so it's likely you'll have to judge which one will be your savings champ. And if you're unsure, you can always seek professional advice.

Now, let's get ready to rumble!


RRSP, the tale of the tax

  • Full name: Registered Retirement Savings Plan
  • Year of birth: 1957
  • Maximum annual contribution: 18 per cent of your earned income up to $22,450 for 2011 (unused contribution can be carried forward)
  • Punching power: Income tax refund on contributions; tax-deferred growth until funds are withdrawn

The RRSP may be intended to help us save for retirement, but we love it because it refunds some of our tax dollars in the spring. Still, the refund isn't an indication we're truly receiving tax savings. The refund merely returns taxes we've already paid on income because contributions to an RRSP are allowed to grow inside the account tax-deferred. You don't pay tax on the money until you withdraw it.

The reason you get a refund is because you're contributing after-tax income that once inside the RRSP "magically" becomes before-tax income once again until it's withdrawn, generally in retirement.

Putting it another way, if you have taxes deducted from your paycheque by your employer, making contributions to your RRSP will get you a refund of a portion of those taxes you've already paid.

For example, $10,000 in RRSP contributions for 2011 would be deducted from your earned income when you file your tax return this spring. If you earn $53,000 at your job in 2011, $10,000 in RRSP contributions reduces your before-tax income to $43,000.

Effectively, by contributing $10,000 to the RRSP, you've had more taxes deducted from your earned income at source by your employer than you should. This will result in a $3,475 tax refund, because the tax rate on income between $41,544 up to $67,000 is 34.75 per cent. And 34.75 per cent of $10,000 is $3,475.

Certified financial planner Bob Challis with Nakamun Financial in Winnipeg says RRSPs are obviously most advantageous to those individuals earning the highest incomes.

Workers earning income at the highest marginal tax rate, 46.4 per cent (that's more than $128,800 in income, excluding capital gains and dividends), can get a substantial refund when they contribute to their RRSP.

But a tax refund on RRSP contributions does not necessarily lead to true tax savings. Tax savings over the long term are generally the goal of an RRSP strategy, but it doesn't always turn out that way.

Here's how RRSP strategy tax savings are supposed to work.

By contributing $10,000 to your RRSP while earning $53,000 a year, you avoid paying a 34.75 per cent tax rate on those contributions. When you withdraw that same $10,000 in retirement, it's assumed you will have a lower income. Let's say less than $31,000.

In that case, you only pay a 25.8 per cent tax rate, leading to almost $1,000 in savings in taxes.

If you factor in pension splitting and the various tax credits, you might end up paying almost no taxes at all on your retirement income.

But a lot of retirees are now finding this strategy has been turned on its head.

"As some people get older, they discover those RRSP contributions have left them with more tax to pay than they otherwise would have had to pay," Challis says.

They might have paid a marginal tax rate of 34.75 per cent while working, but now with their work pension, Old Age Security (OAS) and Canada Pension Plan payments (CPP), withdrawals from their RRSP are taxed at 39.4 per cent or higher.

But the problems don't stop there.

Once you reach 71 you must covert your RRSP to a RIF (Retirement Income Fund), and you must make annual withdrawals from the account.

If your RIF is substantial in size, these mandatory withdrawals may reduce your OAS payments.

Still, facing OAS clawbacks or higher taxes because you have too much money often is better than the opposite scenario: having too few retirement savings. Generally speaking, making RRSP contributions -- even if your motivation is only receiving a tax refund -- is likely to lead to a better retirement situation than a bad one, says retirement planner and author Daryl Diamond.

"If the lure of the deduction incites people to make the contribution to save for retirement, then it's not a bad thing, especially given how low savings rates are," says the planner with Diamond Retirement Planning. If it turns out your RRSP account is too big (you poor thing!), it's likely you have options, such as winding it down early in retirement so you can control how much you can withdraw (as well as the tax rate) before you have to convert it to a RIF, he says.

Yet, if this sounds like a scenario you want to avoid altogether, consider the contender: the TFSA.


TFSA, tale of the tax...

  • Full name: Tax-Free Savings Account
  • Year of birth: 2009
  • Maximum annual contribution: $5,000 for 2012
  • Punching power: Tax-free growth and tax-free withdrawals -- anytime; unused contribution room grows; withdrawals from the account increase contribution room a commensurate amount the following year.

There was an expectation the TFSA annual contribution limit would increase to $5,500 for 2012 to keep pace with inflation. CRA determines whether or not to increase the limit by rounding up or down to the nearest $500. On December 6, CRA stated on its website that the indexed increase is 2.8 per cent for 2012, so the annual contribution limit would remain $5,000.

As of January 1, individual adults will have a cumulative contribution room of $20,000 for their TFSAs. (Only unlike an RRSP, a withdrawal from TFSA can be replaced by an equally-sized contribution the calendar year, or years thereafter, following the year the withdrawal was made.)

All told, Canadian households with two income earners have $40,000 in TFSA contribution room in 2012, making it a formidable savings strategy going forward.

It’s just too bad many Canadians aren’t using it to its fullest advantage, says Carol Bezaire, director of tax and estate planning for Mackenzie Financial.


"The TFSA is totally misnamed," she says. "This is really a tax-free investment account -- not a savings account."

Many Canadians are using their TFSA for short-term goals, investing contributions in savings accounts for family vacations and the like. Although their intentions are good, their strategy is misguided because they're not really saving much in taxes when they're earning, at most, three per cent a year in a high-interest online saving account.

The TFSA potentially packs more punch as a long-term savings tool because contributions can be invested for the long term in equities (the stock market), which have more volatility but should provide better annual returns over a decade or more, Challis says.

And the potential for growth of your money over the long term can be significant, especially for capital gains.

Consider this example. If you were to invest $5,000 in a TFSA, buying the "next Apple Inc." near its lowest point at about $4 a share, you could purchase 1,250 shares. (That's $5,000 divided by the $4 share price.) Fifteen years later, when the "next Apple Inc." reaches $393 a share -- as Apple's share price has done over a 15-year period -- your $5,000 investment would have grown to $491,250. And the CRA gets nothing.

One point of clarification here: If this "next Apple Inc." is a U.S. company, you will not be charged for withholding taxes by the IRS on capital gains in your TFSA, but dividend earnings are subject to a 15 per cent withholding tax. With this example, that's not a problem because the stock doesn't pay a dividend. Even if it did, a 15 per cent tax rate is better than the preferential tax rate on Canadian dividends in a non-registered account, so your investment is still better off in a TFSA. And in case you're wondering, under the tax treaty with the United States, there are no withholding taxes on interest earnings.

Of course, the TFSA is a double-edged sword when it comes to equities, Challis says.

"The downside to that is if you were to buy a RIM-type (Research in Motion) stock, your $5,000 investment could become $2,000, and that is a true loss," he says.

Just like investments in an RRSP, realized capital losses cannot be used to offset taxes paid on realized capital gains. Only investments in non-registered accounts are eligible for that type of preferential tax treatment.

But by making prudent investment choices over time, the TFSA can become your Swiss army knife savings vehicle. You can withdraw money at any time without tax consequences.

And TFSA withdrawals do not affect income-tested benefits such as OAS, which can be clawed back for high-income seniors, or the Guaranteed Income Supplement (GIS) for low-income seniors.


So the winner is...

Sorry to disappoint you after all the hype, but let's call it a draw. The fact is, using these savings tools shouldn't really be looked at as an either-or proposition, Challis says.

"To sort out the TFSA versus RRSP question is something that is unique to each individual's circumstance, because you can't generalize that one is better than the other."

Both have uses and in many cases, they can be used in tandem. While you're working, for instance, you can contribute to your RRSP and then contribute the refund to a TFSA, creating a tax-free income source for retirement. If you're retired, you can strategically withdraw from your RRSP/RIF at a lower tax rate and invest those withdrawals in a TFSA so the money can grow tax-free and be used without affecting your OAS, GIS or your tax situation.

"They're just tools -- like having two different kinds of hammers that can be used for different jobs," Challis says.

Republished from the Winnipeg Free Press print edition December 10, 2011 B12


Updated on Monday, December 12, 2011 at 12:46 PM CST: For TFSAs, the year of birth is 2009 and the maximum annual contribution is $5,000 for 2012.

1:25 PM: Corrects figures for cumulative TFSA contributions.

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