Using a Tax Free Savings Account (TFSA) in Retirement

The Tax Free Savings Account is still a relatively new way to save in Canada. It was introduced by the Conservatives in 2009 as tax-advantaged account unique from the RRSP.

Modeled after the Roth IRA in the U.S.A. and the (much better) ISA in the U.K., a TFSA allows you to contribute after-tax money to an account up to a specified annual limit that increases every few years with inflation. Unused room is carried forward indefinitely.

Once the money is in a TFSA account, you can invest in anything from stocks and ETFs to GICs. Or you can open a simple bank savings account in a TFSA format that earns pitiful interest.

Although the name can be confusing, the TFSA is a flexible account structure, not just a place to park your money at the bank for 0.6% interest. To invest in ETFs and stocks, you should open a self-directed TFSA with a brokerage like Questrade.

All of the investment returns earned within the account are completely exempt from all Canadian taxes, including standard income tax and investment taxes such as dividend taxes and capital gains taxes. Wisely invested, a TFSA should grow into a million dollar account over a lifetime.

As long as you are careful not to double contribute, money can be withdrawn from your TFSA account at any time without penalty. This makes the TFSA an ultimate investment account in terms of flexibility!

Withdrawals from a TFSA are not even reported on your tax return. It is as if you earned nothing at all! The benefits of this should not be understated.

TFSA Statistics

Right now the vast majority of Canadians are wasting the value of this awesome tax advantaged account.

To explain, here are some statistics on TFSAs straight from the CRA.

Canadians with TFSA Accounts:  12,731,020 (about one-half of adult Canadians)
Canadians who Maximized their TFSA:  1,249,900
Average Unused TFSA Room:  $24,191.99
Average Account Value per Holder:  $15,205.96

Even the wealthiest Canadians, those individuals earning over $250,000 per year, are ignoring the power of TFSAs. Of these wealthy Canadians who even bothered to open a TFSA, the average account value lingers around $30,560.

If you were over the age of 18 in 2009 when TFSAs were introduced, there is no reason why you shouldn't have $60,000 or more in your TFSA right now. That is $5,000 contributed every year returning 6% per year. (We have been in a bull market after all...)

Best Use for TFSAs

The TFSA should be used for one thing, and one thing only. Retirement savings! But as I will clarify later, a specific kind of retirement savings.

Any suggestion that TFSAs can be used to save for a new car, buy a house, buy new furniture or a new TV, vacations, or anything else should be dutifully ignored and even scorned.

Anyone who depletes a TFSA while they are young to buy something is a complete idiot! And count me in that category since I did exactly that with my ~$20,000 TFSA in 2011 when I bought a house.

Thanks to aggressive saving after realizing my idiocy and good investment returns, my TFSA and my wife's TFSA are both back in the $70,000 range.

The problem with making early withdrawals from your TFSA is that you lose the investment returns on the withdrawn money.

Plus, if you let the contribution room get away from you, it can become nearly impossible to catch up on your contributions.

If you take just $15,000 out of your TFSA to buy a house when you are 25, you will be $155,000 poorer at 65 years old. That's a wasted potential tax-free investment gain of $140,000.

A TFSA for Retirement

The TFSA account should be used in conjunction with an RRSP (or pension) to save for retirement. When carefully done, you can achieve amazing wealth with extremely low tax liabilities in retirement.

$1,000,000

Source: PortfolioVisualizer.com

If you would have saved just $5,500 a year ($458 per month) for the past 30 years, you would have seen your account grow to $1,000,000.

Returns since 1987 were good, but there's absolutely no reason to believe this won't happen again over the next 30 years. Your TFSA can be worth some real serious money if you invest assertively.

If you get past the constant drama of the naysayers, there is truly no better time financially to be a young saver in Canada! Ignore the mourning of those disappearing crappy workplace pension plans, the TFSA in your own hands is a much better tool.

A TFSA offers fantastic flexibility, affluence, and freedom from taxes. Three things a workplace pension cannot give you.

Effective Use of a TFSA in Retirement

In your retirement savings strategy, your TFSA will form just one component of your total retirement income.

First, there will be the fully taxable income which you cannot control to any significant degree. This includes things like government benefits and workplace pensions.

You may be surprised that this annual income is likely to be $15,000 per person, or more. If you have a larger RRSP or a workplace pension, it can be significantly higher.

By their design, the minimum seniors income after all government benefits is likely to cover the basic costs of living if you have a paid-off residence. A combined annual income of $30,000 should pay for things like utilities, food, a vehicle, and basic entertainment.

Also, after seniors tax deductions, an income of $15,000 per person will be completely tax-free in nearly every province. It may actually qualify you for additional benefits in some provinces.

A TFSA can be perfectly paired on top of this foundation of basic income to keep you completely tax-free in retirement and fully eligible for every government benefit that is accessible to you.

TFSAs should be used as a highly tax efficient way to pay for the extras, especially lump sum expenditures, without jeopardizing your benefits.

TFSAs are a very tax efficient way to pay for things like home renovations, large vacations, new vehicles, or other high cost items.

If you have a larger TFSA, one worth approximately $1,000,000, you can live a truly luxurious tax-free retirement. We know that an account this size can afford annual withdrawals of $40,000 to $50,000 a year.

If both partners in a relationship have large TFSAs, a tax-free investment income of $80,000 to $100,000 a year plus government benefits of $30,000 is a very real and foreseeable scenario for high saving Canadians.

One issue is there already have been discussions about using TFSA values when determining qualification for low income benefits.

It is all but certain sometime in the next decade or two, as TFSA values expand, TFSAs will be considered when applying for benefits. There is a reason why the CRA is tracking this stuff.

Although total net worth and lifetime tax-adjusted net worth may not necessarily be the highest when using a TFSA compared to a RRSP, the TFSA forms a very important part of your retirement savings options.

The flexibility and ease of use of TFSA's are unmatched!

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TFSA or RRSP or Non-registered Investment Account

In Canada investors and savers have three primary accounts in which they can place money for retirement. All these accounts will allow you to invest in a wide range of financial securities. The most common securities include bonds, publicly traded stocks, mutual funds, ETFs, and publicly traded REITs both domestic and foreign listed.

The biggest difference between these accounts is how they impact your personal tax situation. Taxes, unfortunately, can become very complex even at the individual level. This unnecessary complexity is why all these special tax treatment accounts, like the RRSP and TFSA, have been created.

Read this post to get an understanding of investing and investment taxation across different accounts.

The complexity of these special accounts have given a distinct advantage to people who hire professionals to assist them with their finances (generally the wealthy crowd), or Canadians who have taken the time to understand the implications of each account on their wider tax and benefit situation.

Lets discuss the differences between these accounts and which accounts you should choose for your situation.

TFSA

Tax Free Savings Accounts are available to every Canadian over 18 years old. The annual contribution is capped at $5,500 (in 2018), but the contribution room amount is cumulative if you don't put money in your TFSA. You contribute to a TFSA with after-tax money, but you don't pay any taxes on withdrawals. Any investment returns made within the account, including dividends and realized capital gains, are not taxed.

Under the current system, you don't even need to report withdrawals from your TFSA account on your income tax forms. This means, if all your income is from a TFSA, you could appear to have ZERO income and maximize your benefits in retirement--including benefits designed for very low income seniors such as the Guaranteed Income Supplement (GIS).

RRSP/RRIF

Registered Retirement Savings Plan is a tax-deferral account available to every Canadian who files taxes. The annual contribution limit is equal to 18% of your earned income up to a maximum contribution increase of $26,230 (in 2018); unused RRSP room is cumulative and can be carried forward. You get a tax refund for RRSP contributions at your highest marginal tax rate, but you must pay full income taxes on withdrawals from RRSP accounts. Realized income kept within the RRSP account are not subject to tax until withdrawals are made.

Once RRSPs are converted to a RRIF (Registered Retirement Income Fund), any withdrawals you make are eligible for the Pension Income tax benefits and can be split with your spouse. RRSPs must be converted to a RRIF when you turn 71. RRIFs have mandatory withdrawals which are based on your age and the value of the account. The minimum withdrawal rate increases as you get older. You may not make any contributions to a RRIF account.

You can make withdrawals from a RRSP account when you are working, but the withdrawals will be added to your other income and be taxed at full tax rates. However, you can "borrow" money tax-free from your RRSP using the Lifelong Learning Plan (LLP) or Home Buyers Plan (HBP). You are required to "pay back" your RRSP when using these special plans. If you don't make those payments, the minimum required repayment for that year is added to your income and taxed as if it were a RRSP withdrawal.

Non-registered Investment Accounts

These are standard investment accounts which receive no special tax sheltering or deferral treatment. There are no limits on how much money you can contribute to a non-registered investment account, which makes them the default choice once contributions to registered accounts have been maxed.

Taxes on certain types of investment income--Canadian dividends and capital gains--are lower than taxes on employment income. You must pay taxes on any gains you realized during each tax year which reduces your net investment returns. Due to the lower realized investment returns after taxes, registered accounts (RRSP/TFSA) are often preferable to non-registered accounts. You can make your non-registered accounts more tax efficient by investing in products that do not generate income and where capital gains can be deferred for long periods of time. Swap-based index ETFs are a good example of this.

Low Income Comparison ($40,000)

Source: TheRichMoose.com

When you are in a lower income situation, you will find minimal differences between the accounts. From a pure income tax view, the RRSP with reinvestment of the tax refund is the best choice, just slightly beating out the TFSA. That's because you would slightly benefit from the difference between the highest tax rate on contributions and a lower blended tax rate on withdrawals. This small difference is mostly due to the basic personal deduction. Non-registered accounts do quite well for low income individuals because the tax rates on realized gains within the account along the way do not significantly impact returns and can actually reduce your overall tax bill in certain situations.

Middle Income Comparison ($70,000)

Source: TheRichMoose.com

If you are in a middle income situation, you will find the RRSP account with reinvestment of the tax refund to begin pulling away from the other options. The spread between tax refunds on the RRSP contribution and taxes owing on the RRSP withdrawals to increase. Even with relatively careful investing, the actual return on investments after taxes in the non-registered account will begin to suffer more.

High Income Comparison ($120,000)

Source: TheRichMoose.com

If you are a higher income individual, RRSP accounts should be your first priority. The spread in tax refunds on RRSP contributions and taxes owing on RRSP withdrawals continues to grow. Also, you must be very careful how you manage any investments in your non-registered investment accounts because the taxes on realized income there get quite punitive! Again, the TFSA is always a reasonable option that performs well.

It's Not This Simple

If you take a quick look at these charts, you might assume it is always best to invest in your RRSP first--as long as you reinvest your tax refund. While the RRSP is certainly a decent choice regardless of your income, the way our system of tax credits and other social benefits are designed makes it much more complex.

The real answer of the best account for you depends not just on your gross income, but also on your spending and total savings rates. For example, a reasonable person earning $120,000 should be saving much more than $5,500. You should save at least 10% of your gross income if you start young, expect a reasonable retirement, and will have a paid-off house by the time you retire in addition to your investments.

An individual saving $12,000 per year returning 6% over a forty-year period will see their account grow to nearly $2 million. You can't invest $12,000 per year in a TFSA, so you will be forced to save in your RRSP from that perspective. However, if your RRSP is worth $2 million at retirement, your tax rate on $80,000 of RRSP withdrawals will be quite high (22.09%). You will also get benefit clawbacks at this level of income.

RRSP accounts are also less flexible than TFSA or non-registered accounts. When you turn 71, your RRSP must be converted to a RRIF and you must make mandatory withdrawals from the account at a rate that climbs higher every year--even if you don't need the money. Since RRSP withdrawals are taxed similar to employment income, they are more difficult to access during your working years as well.

When RRSPs Should Be Prioritized

Although there are numerous complexities involved and it's never very straightforward, you should consider making the RRSP your first priority if you:

  • Are more educated in financial planning and are serious about reducing income taxes
  • Will always invest the tax refund back into your RRSP
  • Have a moderate to very-high income when you are working (over $50,000)
  • Don't spend a lot of money relative to your income
  • Plan to retire early so you can reduce your RRSP before it must become a RRIF
  • Have a very small amount of money to contribute and want to maximize your total investment value
  • Make sure your RRSP account doesn't get too big so you can keep your withdrawals to a minimum
  • Invest in a more active style, often realizing gains
  • Will not make any withdrawals for any reason while you are working
  • Might use advanced strategies to reduce taxes on withdrawals (borrow to invest strategies)
  • Will go back to pursue full-time education as an adult
  • Are buying a house in the future after not owning a home for four years
  • Plan to take a sabbatical or otherwise reduce your income substantially before retirement
  • Have an uneven income with very high years and low years (self-employed in resource sector)

When TFSAs Should Be Prioritized

TFSA accounts are newer, but they offer many advantages that RRSPs don't. You should consider making the TFSA the first account to invest in if you:

  • Value maximum flexibility in investments, contributions, and withdrawals
  • Want a tax efficient option that performs well in all income and spending situations
  • Believe you might make withdrawals while you are working for any reason
  • Are likely to spend as much, or more money in retirement than when you are working
  • Think your retirement will include large, but in-frequent expenses (travel, new vehicles, etc.)
  • Anticipate moving from a low tax province while working to a high tax province in retirement
  • Are already contributing to a pension plan that will pay a large benefit in retirement
  • Would like to maximize government benefits as a senior (OAS, GIS, Pharmacare, etc.)
  • Invest in a more active style, often realizing gains

When Non-registered Accounts Should Be Prioritized

In general, non-registered accounts are the account of last resort. This means you have contributed everything you can to RRSP and TFSA accounts. However, there are some exceptions and you should invest in a non-registered account first if you:

  • Have a rapidly rising income and will transfer to a RRSP later to maximize your tax refund
  • Invest in a Canadian dividend strategy, have a low income, and live in a low-tax province
  • Are low income and borrow money from a high income spouse (spousal loan)
  • Borrowed to invest in a tax-efficient way and use the interest expense to offset other income
  • Borrowed to invest so that you can maximize your net worth
  • Want to access a wider range of investments without restrictions
  • Are a very active investor who might be considered a "trading business" by the CRA

Mixing Account Contributions

Particularly for higher income individuals with high savings rates, the best strategy is likely to spread contributions across several accounts. Start with aggressive contributions to your RRSP to get large tax refund. Then you will use the refund money and any other savings to maximize your TFSA account contributions. Finally, whatever is left will go into a non-registered investment account. This is the strategy I employ.

I am targeting a sizeable, but not enormous RRSP account. A target valuation of somewhere around $1 million is probably as high as I want to go. This means I will either stop contributing to my RRSP, or significantly reduce contributions to my RRSP as I reach this value. If I can keep RRSP withdrawals under $40,000 a year per person and top up the rest of my income with TFSA withdrawals or dividends from my non-registered account I will be happy. I will also use interest costs to reduce my taxable income from RRSP withdrawals.

Summary

In Canada the typical saver and investor can save for the future in three different account types: the TFSA, RRSP, and Non-registered investment account. The TFSA and RRSP exist to provide savers with distinct tax advantages. TFSA are "tax-free" after your contribution; RRSPs are actually a tax-deferral mechanism, but you save on taxes by getting tax refunds at a high marginal tax rate but pay taxes on withdrawals at a lower blended tax rate after tax credits and deductions.

While TFSA contributions are not tax-deductible, you can invest in your account without being taxed on investment income and you can withdraw money from your TFSA without paying tax on your withdrawal or even claiming it on your income tax return.

You deduct RRSP contributions from your income, so you get a tax refund which should always be invested. You don't pay taxes on any investment income within your RRSP account until you make a withdrawal. RRSP withdrawals are taxed like regular income and you must report withdrawals on your income tax return. When you are retired, you would normally convert your RRSP to a RRIF so withdrawals can be treated as Pension Income for tax purposes. RRSP accounts are more intricate, not very flexible, but offer several embedded programs for earlier withdrawals. RRSPs are the ultimate account for tax arbitrage if you have a good understanding of the tax system.

Non-registered accounts are normally used after you have already contributed the maximum amounts to your RRSP and TFSA. Investment income from this account is taxed, but at preferential rates for Canadian dividends and capital gains on profitable trades. Non-registered accounts might be used first by individuals who are highly active traders, borrow money to invest, or are waiting until they are higher income before moving their investments to a RRSP. High income individuals should avoid realizing investment income in non-registered accounts.

Generally speaking, the RRSP can be the best account for investing even if you are lower income due to tax arbitrage. However, they are somewhat restrictive and require a reasonably good understanding of income taxes and Canada's social benefit system to get the maximum benefit. The average person is probably best off investing in a TFSA because the flexibility is unparalleled and it performs well in nearly all scenarios.

Side Note: I'm on vacation, so my posts next week will be put up a few days late.

Comments & Questions

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Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.