Choosing the right savings account

This year we have a new reason for people to update their financial plan.  The new Tax Free Savings Account should be factored into your savings, especially if you intend to use some of these funds for retirement.

Most financial plans encourage people to contribute to a Registered Retirement Savings Plan.  The number one advantage of RRSP accounts is the tax-deferred growth over time.  The second benefit is the initial deduction for making the contribution.

The new Tax Free Savings Account offers the same tax-deferred growth advantage of the RRSP.   The one downside to the TFSA is that no tax deduction is given for contributions.  The offsetting benefit for the TFSA is that withdrawals are not taxed like they are with RRSPs.

The idea behind an RRSP is that you should be in a lower income tax bracket when you retire than when you put the money in.

Let’s use Jack who is in the 30 per cent marginal tax bracket while he is working.  When he retires he anticipates he will be in a lower tax bracket, say 20 per cent.  If Jack’s income really is in the 20 per cent range at retirement, then the RRSP contributions worked the way he planned.

Unfortunately, we see the opposite happening. People are making contributions when they are in relatively low marginal tax bracket (10 or 20 per cent) while working and pulling the funds out at retirement at a higher marginal tax bracket.

At retirement you’re likely to have income from different sources, although your employment income may be lower.  Most Canadians will be eligible for CPP retirement benefits and the OAS pension.  Most people will have to add other income sources including, investment income, rental income, part time work and registered account withdrawals.

The best part about the TFSA is that it enables people to tax shelter investment income.  It also enables people to have more flexibility to choose when to pull RRSP funds out. Having both a TFSA and RRSP may allow people to take amounts out of both accounts at retirement.  The TFSA is the buffer needed to manage cash flows without the income tax consequence.

Most financial planning software packages do not yet have the TFSA factored in, as it is too new.  Once the software programs are updated we would anticipate savings to be split between RRSP and TFSA.  The deciding factor is likely to be your level of income to determine what type of account you should direct your savings to first.

Low Income

Consider setting up a monthly pre-authorized contribution for the TFSA only.  The reason for this is that you may have little disposable income for savings.  We would recommend you avoid RRSP contributions if your income is below $38,000.  Your RRSP deduction limit will grow so you may utilize deductions in the future when your income is higher.  If you have set up an RRSP monthly pre-authorized contribution, talk to your advisor about changing these monthly savings to a TFSA.

Medium Income

Consider setting up a monthly pre-authorized contribution for the TFSA.  If you have excess cash to invest then making periodic RRSP contributions may make sense.  Prior to making an RRSP contribution you should ensure that the funds are committed to your retirement plan.  It is often people who fall in this category who make last minute RRSP contributions.  The last day to make a 2008 RRSP contribution is March 2, 2009.

High Income

If you are in the top marginal tax bracket then it generally makes sense to take advantage of all tax deferral type accounts.  Most high-income earners will benefit from maximizing both the TFSA and RRSP.   Consider making a lump-sum contribution early in the year for both the TFSA and RRSP.  The maximum 2009 RRSP contribution limit is $21,000.

To summarize the above, nearly everyone should have a TFSA.  People with average income should have a TFSA, and possibly an RRSP provided the funds are committed for retirement.  High-income earners may benefit from contributing the maximum amounts to both an RRSP and TFSA early each tax year.

The first decision you will have to make is the type of investment account to put your savings in, and then decide which investments to purchase in that account.  Over your life, the direction of your savings may change primarily based on your income level.  With each significant change, your financial plan should be updated.