So Arlene has $17,000. Lucky girl. “But where do I put this money?” she asks me in an email. “In my retirement plan, or my tax-free savings? I’m so confused. And the bank is no damn help.”
This question arises more times than you might think. More than I thought. So as we near the RRSP deadline (Tuesday at midnight), here are some facts to bear in mind – followed by my conclusion.
First, an RRSP is a registered retirement savings plan. Who’s it registered with? The government. Why do we have it? Because we suck at saving money, so this is supposed to be an irresistible incentive to change that. Funds put into an RRSP net you a tax rebate. Plus, money earned inside is untaxed until it’s removed, so stuff grows faster.
An RRSP is not a product. Not a thing like a GIC or an ETF. Instead it’s just a way of investing – an empty box into which you place various assets like stocks, mutual funds or your mortgage. This is also the same for the TFSA, which is definitely not a savings account despite its dumb name.
Now the RRSP has two major problems. First, it doesn’t eliminate or reduce taxes. It just shoves them off into the future. This is called tax deferral and for many people it’s not cool. Especially young people. That’s because all the tax you save by investing in an RRSP needs to be repaid when you retire and withdraw, at current tax rates. And where do you suppose tax levels will be in, oh, thirty years?
You bet. Sick. After staggering through years of giant health care bills for the resource-sucking Boomers plus endless government deficits, there’s every reason to believe marginal rates could be far higher on RRSP cash you withdraw than the tax break you got going in. This is also a big deal for people closer to retirement who have investment or pension income that will give them a solid income after working. By age 71 the feds force you to start cashing in RRSPs and adding the money to your income – which can kick you into a higher tax bracket, or tax the poop out of your state pension payments.
RRSP problem deux: all the money coming out of an RRSP is taxed the same way. Viciously. It’s simply added to your taxable income in the year it is taken, and subject (as I said above) to your marginal tax rate. That also sucks because it wipes out a lot of the advantage of investment income.
Here’s what I mean. If you invest in, say, ETFs or preferred shares outside of an RRSP the returns they generate for you are taxed as either capital gains or dividends. That means you’ll have a tax rate of maybe 20% – with the other 80% free. This is delicious, and one reason why these assets beat the pants off pathetic GICs whose interest is 100% exposed to tax.
But when you put preferreds or ETFs or stocks inside an RRSP this tax advantage is totally lost. All the gains are nailed the same way – as earned income – when they’re taken into your hands in retirement. This, by the way, is an investing mistake made by untold numbers of do-it-yourselfs who think they’re smart to stuff their retirement plans with hot stocks. It’s that flinty little F who gets the last laugh.
Now, life inside a TFSA is totally different. With this vehicle (it, too, is not a product but a way of investing) taxes are actually eliminated, not just deferred until you need Depends and help putting your pants on. This means there ‘s no deduction against taxes granted when you put money in, but neither is there tax when you take it out. Every cent you contribute, and all the growth earned over the years, is yours to keep.
Also nice is the fact you can take money out of a TFSA and replace it later, hold all kinds of investments inside (but never in the Orange guy’s shorts, please), and open one for your spouse and kids over 18 to split investment income within the family. Profits earned here do not even show up on your tax return, so they result in no claw-back of government pension income nor do they goose you into a higher tax bracket.
The downside is only $5,000 a year can go into a TFSA (or $10,000 with your spouse), compared to $22,000 a year in the RRSP (if you make over $120,000). But with both plans, unused contributions from past years can be saved up and dumped in at any time. Check out your Notice of Assessment for unused RRSP contributions (called ‘room’), while everyone is allowed to put $15,000 in their TFSAs, since the plan is now three years old.
Of course, smart people make use of both. And let’s not forget that new homebuyers can suck off $25,000 from an RRSP for a house downpayment (although there’s only one reason to do so – using the refund to increase your deposit. Otherwise, bad idea.) Plus you can get an RRSP loan at the bank and then use the tax refund to repay it. And, of course, people with investment assets but without cash can simply shift those things into either a TFSA or an RRSP, which is called a ‘contribution in kind.’
The bottom line? Should be obvious. The first five grand you can find every year goes into the TFSA, and into growth assets – not some pantywaist GIC. The next money goes into an RRSP, in an amount sufficient to offset any current-year tax liability. (Unless you plan on having a pregnant spouse in a few years, then money into a spousal plan now can net you a tax break while she can withdraw it at a cheap rate later to finance mat leave.)
Or, you can pretend you’ll never retire, embrace hedonism, spend your money on tats and women, buy a Hummer and start a finance blog.