RRSPs/RRIFs/TFSAs

RRSPs I think pretty much everybody in Canada knows how RRSPs work so I’ll confine myself to describing what I like and dislike about them. I like that they encourage people to save long term for their retirement. I like that they can grow tax deferred for a long time. The advantage to tax deferral is that you can have growth on the growth (as Einstein said "The most powerful force in the universe is compound interest"). So even if your marginal tax rate is the same as when you were accumulating the RRSP assets, you can end up with more capital than if you paid the tax on the growth each year. And for many people, their marginal tax rate when they retire is actually lower than when they were accumulating.

Here's what I don’t like about them. First of all, tax changes over the last couple of years means that for non-registered investments (RRSPs, RRIFs, and RESPs are all registered investments), capital gains are taxed at 50% and dividend income is taxed at roughly 50% depending on what province you live in. These are absolute tax savings, not just deferral. And with capital gains we also have deferral – we don't pay tax until we actually sell the investment. Together these measures make RRSPs less attractive in comparison, because the absolute tax savings on capital gains and dividend income are lost when the investment is held within an RRSP.

Let me tell you a little story. I have clients who have almost all their assets in RRIFs (RRIFs are simply RRSPs that have been converted after retirement to an income producing vehicle). She has a good pension. With their normal RRIF payments and pension income, they both have taxable income at around $80,000 each. For anything they earn over $80,000 their OAS starts to get clawed back. At about $129,000 it is totally clawed back. This makes their effective marginal tax rate in this range about 52%. Now what happens when they want to go on their Florida vacation (about $15,000), European cruise ($10,000) or pay for their boat at the marina ($12,000)? As soon as they withdraw from their registered assets, they have to pay 52 cents on the dollar. Not good!

So for anybody with a good pension (teachers, government employees, employees of any large corporation etc.) accumulating RRSPs doesn't make sense to me. If the couple above had accumulated non-registered assets, they would have had a fair bit of tax deferral and they would have had absolute tax savings on capital gains and dividends. They would only pay a little capital gains on their capital when they withdraw it.

Planning point: keep you conservative interest bearing investments in an RRSP and your equity investments that generate capital gains and dividends in your non-registered plans (including TFSAs).

There are lots of people out there who have pension incomes or will have them in the future at around $65,000 so they potentially face a very high tax rate (higher than Hal Jackman, or Paul Desmarais). Keep in mind that when the last spouse dies, the entire RRSP or RRIF is added to their income for the year, so if it is a sizable amount, a large chunk of it will be taxed at the top marginal rate i.e. up to 52%.

How about spousal RRSPs? I don’t much see the point of this added complexity now that we can split pension income (more on that elsewhere) so I wouldn't even bother with these now. Bottom line here is that I think you should reach retirement with a combination of registered or pension funds and non-registered capital.

RRIFs RRSPs are an accumulation of contributions that create a tax deduction in the year of the contribution or 60 days in the year following. RRIFs are converted from RRSP plans and in work in reverse fashion, that is, they allow you, the planholder, to continue to defer tax but you must withdraw a prescribed amount each year and pay tax on this withdrawal. You must convert your RRSP to a RRIF by the end of the year you turn 71. RRIF income received after you turn 65 is eligible for both the $2,000 pension income credit and income splitting (more on that elsewhere). One small planning point is that if you don’t need the full RRIF payment, and you have a younger spouse, you can have the payments based on your spouse's age.

TFSAs These are a great way to save non-registered capital for your retirement. Although you don’t get a deduction at the time of contribution, you don’t have to pay tax on your later withdrawals, so it avoids the problems I described under the RRSP section. I think these are particularly useful for those with good pensions, limited RRSP contribution room (usually the same folks), or uncertain income (because they can be accessed with no penalty in case of emergencies). If you have an investment that you think will go to the moon, put it into a TFSA. Or alternatively, if you have a special fund for emergencies, or a savings account, move the funds over to a TFSA. In other words, a TFSA is good for both conservative and aggressive investments.