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.
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.