TFSAs, RSPs and Myopia
I must tell you, I am thrilled to finally see and hear all the commentary on whether it is a good idea to use a Registered Retirement Savings Plans (RSP) or not. That it took the introduction of the Tax Free Savings Accounts (TFSA) to allow such commentary is however very disappointing. As I have said many times before, where were all the financial planners?
Every year at this time, we are inundated with radio, television and print ads that make no distinction as to who should be using RSPs. In fact, quite the opposite is true, and everybody that has a pulse and an income last year is encouraged to get that deposit in before March 1st. I am sure my newspaper delivery boy will be in the line up, since he seems like a nice, responsible kid. The truth is, even before the introduction of the TFSA, RSPs were not wise choices for many individuals. Why? First. Taxes! More specifically YOUR taxes. The announcer, the actor, nor the writer of those ads, knows anything at all about YOUR taxes. Second. Refund myopia! How can we not love the idea of getting a cheque in the mail, from the government no less. Short sightedness triumphs and we see the benefit of an instant refund without adequate evaluation of the eventual taxes. All we see is that if we deposit $1000 we get a refund of $200, $300 or even $500. We have immediately turned a $1000 into as much as $1500. Wow! What is being missed though, is would you be as happy if the opportunity was presented as, “If you give me a $1000 dollars now, I will give you in return $200 immediately and maybe $500 or $666 or maybe $540 at a later date.” Would you take that deal? Every year many do and all scenarios mentioned total less than the original $1000 deposited. How can that be the case? Well, the explanation is in YOUR taxes.
The basic reason for RSPs is to ease your accumulation of retirement assets and thus increase your retirement income by giving you some tax advantages. However, there is a basic assumption built in, that your future marginal tax rate will be the same or lower than your tax rate at time of the deduction. This is a very flawed assumption. As a tax preparer I can tell you that there are many individuals that have higher marginal tax rates in the future and will therefore pay more taxes than the refund they have received. How? Individuals that have incomes below the first marginal change, $37,106 in Ontario, are getting a refund of 20% of their deposit to an RSP. That is the $200 refund scenario that I referred to earlier. Later when they withdraw the original deposit in retirement, it is possible that: a) they would reduce their Guaranteed Income Supplement – the reduction is 50% of any new income (the withdrawal) or a $500 loss on the $1000 withdrawn. This is the get $500 later part; b) they die without a spouse (either they never had one or spouse is predeceased) and this pushes them into a higher marginal bracket. This new unexpected marginal bracket will very often be between 33% and 46% in Ontario. This is the $667 or $540 later part. Unless you die with your RSPs (or RIFs) empty, and few seem to, this will be the norm not the exception; c) a lump sum is withdrawn from your RSP, which will most surely cause a jump in your marginal rate.
To counter these problems, financial planners and advisors will trot out the advantages of tax free compounding within the RSP. This advantage is quite true and very important to the decision to utilize RSPs. However, have you ever seen an analysis based on a lifetime at the lowest marginal tax rate all the way to death? The best possible outcome is realizing the full benefit of this tax free compounding feature, but at the great risk of having a withdrawal and certainly the last final withdrawal at a higher marginal rate. This will undo the tax free advantage and more. Many financial planners might agree that the above situations could exist, but it will not be the case for you. My only answer is that they should prepare more tax returns, where the damage is observed readily.
TFSAs are a good alternative to this problem. Possibly a great alternative to YOUR problem. Why? Simply because you get the exact same benefit of tax free compounding without the risk of undoing this advantage with an untimely or final withdrawal. Your tax free advantage is assured. With a RSP, it is anything but. TFSAs allow you to contribute $5000 per year for every year you are 18 or older after 2008. Any income earned will NEVER be taxed. Yet the funds are readily available for withdrawal (subject to how it is invested) at any time. They are an obvious good choice for non-RSP funds, but even so they need to be integrated properly into your investment plans, because they do carry a few disadvantages. The most obvious one being some forms of investment income or gains are taxed at preferential rates and this preferable rate is lost on those assets when placed inside a TFSA. Your choice of what investments to be carried inside the TFSA, your RSP and outside of both still requires careful thought to maximize the available tax advantages.
So who should feel comfortable using RSPs to the maximum allowed? If you earn more than $150,000, do not even slow down for the speed bump in the bank parking lot. You can only gain, unless we see a substantial rise in the future highest marginal rate. If you earn more than $75,000, hesitate only long enough to ponder whether you are planning to die before you even get to retirement. The odds of RSPs being a winning strategy are very high indeed. If you make less than $75,000 make your financial planner do some work and carefully evaluate your situation before continuing to make contributions each year. If you make less than $37,000, do not make an RSP deposit, until you or your financial planner have very carefully considered your particular circumstances. TFSAs should be used by all AFTER following the RSP advice appropriate to them.
RSPs can be important tools for ensuring a good retirement. Like any tool though it needs to be used carefully, respecting its ability to hurt you in an instant. TFSAs on the other hand will likely only prove dangerous if you over use them, since the penalties for contributions in excess of your available allowance are severe. As always, when using tools wear safety glasses, in this case glasses geared to treat myopia.
Value For Money Investing means we wish to allocate and use our hard-earned resources in order to improve investment outcomes in a continuous and sustainable way at a fair and equitable price. In other words, achieve good investment returns AND receive fair value for the services provided. Costs do matter!