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By John De Goey
Special to the Financial Independence Hub
Canadians are notoriously nice consensus seekers. The old joke might be that they tend to never cross the road because they consistently prefer to be in the middle. If that’s the case, I’d like to propose a “Canadian” solution to the ongoing debate about how much should be allowed to contribute to their TFSAs annually.
You may recall that the limit is currently set at $5,500 and is likely to go up to $6,000 in a year or two (TFSA contributions are indexed to cumulative inflation and go up in $500 increments when thresholds are passed). You may also recall that for one brief year, the limit was set at $10,000 in keeping with a political promise made by a party that is no longer in power in Ottawa. The debate, it seems has mostly revolved around the benefit of incremental tax relief for those who might not need it.
You may recall that I have argued that there is an unfair cap put on RRSP contributions because the 18% limit that applies to most people essentially penalizes the small percentage of Canadian income earners who make more than about $145,000 a year. Similarly, some people like CIBC’s Jamie Golombek have pointed out that many Canadians are opposed to using RRSPs because they will end up paying tax down the road when making RRIF withdrawals. The point made by Golombek* and others including yours truly is that people should be thinking about the concept of ‘tax bracket arbitrage’ when contributing to government plans. If you’re in a higher tax bracket now as compared to in retirement, contributing to your RRSP makes more sense. If you’re in a lower bracket, the TFSA makes more sense. If you think you’ll be in the same bracket, it makes no difference.
Middle class threshold
As a practical matter, the line probably ought to be drawn at the federal tax bracket that kicks in at around $46,600 – the same bracket that the current government used as the threshold in determining who is in the ‘middle class’. As long as your income is at or below that amount, the odds are high that you should be indifferent between the two programs. Obviously, if your income is even a little bit higher (say just under $60,000), you could likely put all your money earmarked to pay for retirement (i.e. 18% of the previous year’s earned income) into an RRSP and get a bigger deduction for doing so. Once your income drops to about $46,600, however, you should be indifferent.
If the government is serious about helping people make informed and purposeful decisions about funding their retirements, it logically follows that public policy should promote decision-making that promotes an understanding that the decision often depends on the point of indifference from a tax perspective. If one were to be indifferent between making an RRSP contribution and a TFSA contribution for all income up to $46,600, it stands to reason that contribution room ought to be comparable too. For those doing the math in their heads, I’ll spare you the trouble: 18% of $46,600 is $8,388. In keeping with the principle of moving in $500 increments, I’d like to propose that the TFSA limit be moved to $8,500 and indexed to the middle class tax bracket (in $500 increments) going forward.
Linking the contribution room to a tax bracket (which is also indexed to inflation) is the clearest indication I can think of in making the point that the financial planning 101 question of ‘RRSP or TFSA?’ should hinge primarily on your taxes.
The other interesting wrinkle in this idea is that the federal government has raised taxes on the top 1% of income earners. The line was drawn at $200,000 initially, but it has since crept up as well, due to indexation. By combining RRSP contribution room (a little over $26,000 now) with an additional $8,500 in TFSA contribution room, most people could save about 18% of their earned income in government-sponsored programs up to just below the point where they are earning $200,000 annually. It seems to me that if the government won’t increase RRSP contribution room for high earners, a reasonable alternative might be to modestly increase TFSA contribution room for everyone.
John De Goey is a Portfolio Manager with Industrial Alliance Securities Inc. The opinions expressed herein are those of Mr. De Goey alone and may not be aligned with the opinions and values of Industrial Alliance Securities Inc. or any of its affiliated companies. IAS is a member of the Canadian Investor Protection Fund (CIPF). This piece originally appeared at MoneySense.ca and is republished on the Hub with his permission.
I’m onboard with this idea. I have a very small rrsp and a maxed Tfsa. There could also be an either or option?