Sunday, 31 January 2010

New Data on TFSA vs RRSP and Canada's Rube Goldberg Tax System

Cartoonist Rube Goldberg was famous for his drawings of incredibly complex, convoluted machines. That's Canada's income tax system. A new paper from the CD Howe Institute Saver’s Choice: Comparing the Marginal Effective Tax Burdens on RRSPs and TFSAs (kudos to Don Cayo of the Vancouver Sun on whose blog I found the link) reveals the gory detail of the complexity created by the interaction of all the start and stop levels of tax credits, tax brackets, tax surcharges, rebates and clawbacks. The table they show for an Ontario taxpayer has no less than 33 income levels at which tax rates either go up or down. Contrary to popular belief, the tax you pay on your next dollar of income, the marginal rate, does NOT go up constantly and smoothly. It bounces up and down by more than 100% for very small rises in income. These tax items are not special rules for individuals in unique circumstances, it is what everyone faces.

What's more, and what is important for the average person trying to decide whether to put savings into a TFSA or an RRSP, as a result the better choice flip-flops back and forth between TFSA and RRSP. The answer varies by: Province, by income in retirement compared to during working life (the replacement rate) and by working life income level.

CD Howe's Findings
  • $20-30,000 or so working income, TFSA always is better and by a massive amount, the GIS clawback being the primary cause as TFSA withdrawals are not included as income for the calculation while RRSP withdrawals are included.
  • $35-45,000 or so working income, RRSP is better but not by nearly as much as the TFSA advantage in the bullet above
  • the boundary between TFSA and RRSP shifts higher as retirement income replacement is lower e.g. in Ontario, at 80% retirement replacement, the TFSA is better up to around $30,000 working income but at 60% replacement, the TFSA is better up to about $39,000
  • TFSA is better across most of the working life income spectrum for Alberta and Quebec and most income replacement levels
  • most surprising, TFSA is everywhere best for the highest income earners of $110,000+ even when their income replacement is only 60% - one would have thought they would end up in a much lower tax bracket and thus conform to the general principle that RRSP is best when your tax rate is less in retirement.
  • above low income levels, the advantage for TFSA or RRSP is not enormous (less than 10%+/- in marginal tax rate), except for huge spikes up or down in Ontario
  • a change of only a few thousand dollars in working income can shift the balance, sometimes drastically, from TFSA to RRSP or vice versa, especially in the band $35,000 up to about $80,000 in Ontario (which leads me to conclude that Ontario residents face the most uncertain, difficult and chaotic tax system as far as TFSA vs RRSP planning goes)
Ontario residents in the income range from $35,000 to about $90,000 probably need most to hedge their bets about where their retirement tax rate will end up and to contribute to both their TFSA and RRSP. At least both benefit from the powerful advantage of tax-protected compounded growth while funds are in the plan.

Unfortunately, CD Howe only looked at the numbers for Ontario, Alberta and Quebec, so taxpayers in other Provinces must be wondering where they stand. Don Cayo got preliminary data from CD Howe about BC, which he says is similar to Ontario.

The Federal government could do us a favour by expanding TFSA contribution room to make it equal to the RRSP, or make it a combined total that people can divide between the two as they choose.

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