RRSP or TFSA with a Defined Benefit Pension?

With the Tax Free Savings Account (TFSA) introduced a couple years ago, it added quite a bit of complexity with regards to retirement planning.  To the financially savvy, the TFSA was quite the gift as it’s a powerful tool that compliments retirement planning.  One question that relates to the TFSA that I get often over email is what do when an investor has a defined benefit pension plan (DBP), should the priority be the RRSP or TFSA?

A Little Background

To take a step back for a moment, a defined benefit pension plan is a retirement package typically given to government workers which entitles them to a guaranteed monthly payment  for the remainder of their retired lives.   Providing the employee works with the employer for 25-30 years, they’d most likely be entitled to a annual pension in the range of 50-70% of the average of their best 5 years of service.  While the guaranteed payment is a great benefit, there are tax implications that should be considered for retirement planning.  Specifically, the government employees out there that save more than their pension contributions.  With the extra money, I usually suggest to pay down all debt first, but what about after all debt is paid off?  The first thought is usually to either put it in an RRSP or perhaps the new TFSA.  But which is the best choice?

TFSA vs RRSP

Both the TFSA and RRSP seem like a reasonable choice as  investment  tax shelter, but the major differences come out during retirement years especially those with a defined benefit pension.  As you most likely understand already, RRSP contributions are made with pre-tax dollars, but the government wants the money back some time along the way, which is why RRSP withdrawals are added to income that tax year and taxed at marginal tax rates.  The TFSA, on the other hand, works in reverse.  That is, TFSA contributions are made with after-tax dollars, but withdrawals can be made tax free.

During retirement years, the goal is to keep taxable income as low as possible because of the various clawbacks of seniors benefits as incomes rise.  These clawbacks include guaranteed income supplement (DBP recipients will likely get this clawed back anyways), age amount, and old age security.  There are a few methods of reducing  taxable income during retirement among the most effective is perhaps pension/income splitting.

As mentioned, RRSP withdrawals are considered taxable income, thus in addition to paying tax, the added income can have adverse affects on seniors benefits.  TFSA withdrawals are considered tax free with the added strength of not affecting seniors benefits which is the reason why I believe that government employees with DBP’s should utilize TFSA’s before RRSP’s.    First, the RRSP withdrawal when added to the DBP income, will result in the RRSP withdrawal owing relatively high tax.  Remember, the goal of the RRSP is to contribute when taxes are high, and withdraw when taxes are lower.  Second, as mentioned, the added income can negatively impact seniors benefits.  For example, the old age security clawback starts at the income threshold of approximately $66,700 for 2010.

Final Thoughts

In conclusion,  for those with defined benefit pension plans with expectations of full benefits during retirement, it may be a wise tax strategy to go with contributing to a TFSA before an RRSP.  TFSA withdrawals are tax free and do not test seniors benefits which means you may end up with more money in your pocket.

Here is more information on seniors clawbacks.

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FT

FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.
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RENE
9 years ago

RC
I”m retired now, and receiving a small amount of DBP. I do received CPP too.My problem is every year end i still have. to paying Taxes. Since, my RRSP contribution is still not max. I take the full advantage of contributing to avoid paying more taxes each year. I don’t know if this is the right way since I’m retired now. will I better be off contributing to TFSA? and just pay the taxes that I owe every year?. OH! just to let you know, there’s very little tax deduction being deducted on both Plan,because I do need all the money that is left to survived.Am I doing the right thing? please help.

Future Money-Bags
10 years ago

@Brian
Well I do not have a pension, nor do I ever plan to have one.
If I were to contribute $10,000 to my RRSP this year, I would indeed get $2,000 (roughly) in return, as long as I remain in the 20% marginal tax bracket, correct? I would than put my $2k return into my RRSP the following year, and keep the unused contribution room for later years when my tax rate is above 35%.
I believe it is very important to start your RRSPS early on to take advantage of the ‘rule of 72’. This means that the more doubling periods that are in my life, the more my money will double until the age in which I retire. “The most powerful force in the universe is compound Interest”.

I have small investments going into my TFSA using DCA, to take advantage of all the highs and lows of the stocks.

PS. Just because I am only in the 20% tax bracket, no reason to be so quick to assume I have any sort of limited cash flow, or that I know nothing about how taxes work. I also do not intend to rely on CPP or OAP from the government when I retire, that is why I save over 50% of every penny I earn.

I come to MDJ to learn more things that I do not fully understand, so if I have came off on the side of not understanding what you have messaged me, than I would be quite happy to learn something from you :)

Raj
10 years ago

Hi FT,

To your question in Point 17 above, I believe different companies do it differently. For example, I’m in a DB plan with a non-govt organization; On retirement, they take in the best 5 years income of the last 10 years prior to retirement to come up with the pension income.

Another aspect to this is inflation protection. For example, my DB plan is not indexed for inflation.

Thanks for the informative article.

Brian Poncelet
10 years ago

@Future Money-Bags,

If you are getting only 25% back and have limited cash flow your best idea is go for the TFSA. Remember any gains you make CRA is your partner. If you do a great job saving you will be taxed at a much higher rate than 25% when you retire.

Since most people do not do, or understand taxes or how the tax system works… getting a “tax refund” is a common mistake. You may want to re-read FT comments on OAS, age amount etc. Also, the trend for the government is to pay you much less for CPP payments the government have made major changes to CPP already.

cheers,

Brian

Future Money-Bags
10 years ago

Only 10% of Canadians maximize their RRSP contributions each year.
I believe there is over 600billion in unused contribution room. I don’t see why more people are not taking advantage of this.

I will be starting one in December, I don’t have tonnes of room as I am fairly young, but by putting in $10,000 I will get a nice $2500 tax refund to put back in. Than compound interest and a few worthy investments, and it will be very worth it.

Miguel
10 years ago

, tough decisions always re: debt or savings. We do have a mortgage @ prime -0.65, but investments are sure to pay back much more than this in dividends alone atm. So, overall, I think savings in this environment is the more sure-fire way to go! If interest rates start to increase significantly, then re-evaluation would be needed….

Maltese
10 years ago

Just for clarification, it’s not just government employees who have DBPs. Many large companies and banks also offer them.

In general though, I found your article to be informative. It’s too bad that TFSAs weren’t created years ago so that us older folks could have taken greater advantage of them. But, better late than never as we will be able to make use of TFSAs in the future.

Are you aware that income from RDSPs also do not impact senior’s benefits? I’ve seen very little written on this topic so perhaps it would be a good one for you to tackle in the future.

Miguel
10 years ago

I have a DBP, still 20 years from retiring at 55 though, and I plan on continuing to use my limited RRSP room. With the return I’ll get each year, I’ll use the proceeds to invest in my TFSA (or keep the RRSP contribution going). So why not have both??

JFG
10 years ago

I just find it amazing the amount of people not using tax strategies. RRSP is tax DEFERRED, TFSA is tax free. No brainer to me, as I do not need the tax savings of the RRSP.

Also, ITS, you can have any investment in a TFSA. From Savings account to Mutual Funds to Stock and more. You should try it for investing, instead of saving. Always amazes me that people haggle over half a percentage point.