Here's why your tax bracket matters when you're making the RRSP vs. TFSA decision

National Post

2020-02-28


The RRSP deadline for 2019 is fast approaching. You only have until midnight on Monday evening March 2, 2020 to make your contribution if you want to claim a deduction on your 2019 tax return, which is generally due on April 30, 2020.

HOW MUCH CAN YOU DEDUCT?


You can claim a deduction on your income tax return for RRSP contributions up to 18 per cent of your “earned income” for the prior year to a maximum of $26,500 for 2019, minus any pension adjustment, plus any unused contribution room from prior years. Contributions in excess of this amount could be subject to penalties and interest.

You can find your RRSP deduction limit, often called your “contribution room,” by going to the Canada Revenue Agency My Account website, or by using the MyCRA mobile app or the Tax Information Phone Service (TIPS). You can also check your limit by reviewing either a Form T1028 that the CRA may have sent you if there were any changes to your RRSP deduction limit since your last assessment, or by taking a look at your latest notice of (re)assessment, under the heading “Available contribution room for 2019,” found on the RRSP Deduction Limit Statement.


  • RRSP OR TFSA?


Still in doubt about whether to contribute? Then this column is for you. Let me begin with a bold statement that is likely to shock some readers: Saving for retirement via an RRSP is just as “tax-free” as saving for retirement in a Tax Free Savings Account, assuming your tax rate in the year of contribution is the same as the rate in the year of withdrawal.

That’s right — an RRSP, just like the TFSA, allows you to earn tax-free investment income. But in many cases, if you don’t have the funds to maximize both plans, contributing to an RRSP can provide a significant advantage over contributing to a TFSA if your income, and thus corresponding tax rate, will be lower in retirement.

STORY CONTINUES BELOW

JACK AND DIANE


Don’t believe me? Here’s a little ditty about Jack and Diane, two Canadian taxpayers growing up in the heart of Ontario. Each of them earns $60,000, which puts them in the 30 per cent Ontario marginal tax bracket.

Jack wants to save for retirement and sets aside $6,000 of his income in an RRSP by making a tax deductible contribution. So, at the beginning of the year, his RRSP is worth $6,000 and, assuming a five per cent rate of return, will be worth $6,300 at the end of the first year. Jack decides to cash in the funds after the first year, and includes the $6,300 in his income. Still at a 30 per cent marginal tax rate, he would pay $1,890 of tax on the withdrawal, and net $4,410 in cash.

Dianne goes the TFSA route. Because she is not putting $6,000 of her income in an RRSP, she will not get an RRSP tax deduction and will have to pay tax on that income currently before contributing to her TFSA. At 30 per cent, her tax bill is $1,800 and she takes the after-tax amount of $4,200 and sets it aside in a TFSA, where she invests the funds to also earn five per cent. At the end of the first year, her TFSA is worth $4,410, which she can then withdraw tax-free, netting her the same after-tax cash as Jack.

In both cases, Jack and Diane have each been able to earn a five per cent tax-free rate of return equaling $210. In Jack’s case, that return can be calculated simply as the $300 increase in the value of his RRSP, less $90, which is the 30 per cent tax associated with that growth (i.e. 30 per cent X $300). In Diane’s case, her five per cent tax-free rate of return of $210 is simply $4,200 x 5 per cent.

Now, the above example assumes that both Jack and Diane are in the same tax bracket today as they will be when they retire. Let’s now consider the case of Brenda and Eddie.

BRENDA AND EDDIE


Brenda is an executive earning $150,000 annually, putting her in a marginal tax bracket in Ontario of 45 per cent. She contributes $6,000 to her RRSP and retires next year. Her post-retirement income drops to $70,000 annually, putting her in a post-retirement tax bracket of 30 per cent. Her RRSP investment earns five per cent and is worth $6,300 after one year. She cashes in her RRSP, pays tax of 30 per cent and nets $4,410, just like Jack.

What if Brenda had chosen the TFSA route instead? She would have paid 45 per cent tax or $2,700 on the $6,000 of income, leaving $3,300 to be invested in her TFSA. After one year at five per cent her TFSA would be worth $3,465, which she could withdraw tax-free. Clearly, making an RRSP contribution, as opposed to a TFSA contribution, was the right move for Brenda.

Eddie, however, is in the opposite situation. He’s currently making $40,000 annually, which puts him in the lowest Ontario tax bracket of 20 per cent. Next year, Eddie gets a promotion and an accompanying raise to $50,000 annually, which moves him up into a 30 per cent tax bracket. Expecting this promotion, Eddie decides to start saving for retirement in his TFSA, setting aside $6,000 of his income for the future. He pays tax in the current year on the $6,000 of income at 20 per cent ($1,200) and invests the $4,800 net amount in his TFSA in an investment that earns five per cent. Consequently, after one year, his TFSA would be worth $5,040, which he could withdraw tax-free.

What if Eddie instead had simply made a $6,000 RRSP contribution? He would have been worse off. While his $6,000 would grow to $6,300 in his RRSP, if he cashed in his RRSP next year when his tax bracket was 30 per cent, he would pay $1,890 tax on the withdrawal and net only $4,410, the same as Jack and Brenda. He would have been better off steering clear of the RRSP and focusing on his TFSA.

Bottom line? If you expect to be in a higher tax bracket (including taking into account the impact of the loss of income-tested government benefits and credits, such as Old Age Security and the age credit) when you retire than you are in today, go the TFSA route. But for many of us, who will likely be in a lower tax bracket when we retire, RRSPs continue to be the way to go if you don’t have enough funds to maximize contributions to both.