Why you should use a TFSA to save for retirement

Only half (51%) of Canadians aged 45 and older intend to use a Tax-Free Savings Account (TFSA) to provide retirement income, according to the 2020 Fidelity Retirement Survey, viewing it primarily as a short-term savings account and leaning more on Registered Retirement Savings Plans (RRSPs) for retirement investing.

This approach may be a bit short-sighted, although that may only be evident as they get closer to actually leaving work behind. More and more retirees are discovering that TFSAs, although generally underutilized, are a key component of a well-rounded retirement plan.

There are several ways you can put a TFSA to work. Most typical are near-term objectives such as buying a new car or saving for a vacation, as well as setting aside cash for a down payment on a home. But it’s when looking longer-term toward retirement that the tax-free benefits of TFSAs really stack up.

It’s important to realize that your TFSA investment choices go far beyond plain vanilla savings accounts and include the types of wealth-building investments you use in an RRSP. These include mutual and exchange-traded funds, stocks and bonds.

Carefully balance TFSAs and RRSPs

“Most Canadians have both short- and long-term financial goals, and when it comes to long-term retirement planning, using a combination of TFSAs and RRSPs is often the way to go,” says Michelle Munro, Fidelity Canada’s Director of Tax and Retirement Research. “But getting the mix right can be tricky without the correct kind of advice – particularly when you’re looking so far into the future.”

While a few fortunate people have enough money to max out their RRSP contributions and put money in a TFSA, many more won’t be able to afford to do both. Each account offers relative advantages, depending on your tax rate, the timing of your contributions and when you actually retire. But they both have one thing in common: the earlier you put the power of compound interest to work, the more impressive the potential long-term results.

If your career is just starting, or even if you’re further into it and not yet making as much as you one day will, a TFSA will usually make more sense. An RRSP will likely win out later in your career, because that generally includes your highest-earning years.

The big difference between an RRSP and a TFSA is the timing of the taxes you’ll eventually pay. A good strategy is to contribute to an RRSP if your marginal tax rate is higher at the time of contribution than you expect it to be in retirement. That way, you’ll benefit from the deduction today at a higher tax rate, and potentially find yourself in a lower tax bracket in retirement when the withdrawal is included in income.

This is a common scenario for many Canadians, because those who are currently retired generally manage on less than what they made when they were working.

If you can’t yet make good use of that deduction, though, a TFSA will be the better bet. Not sure what the future holds tax-wise? The good news is that you can move your TFSA money to an RRSP at any time without tax consequences.

Building a tax-efficient retirement

Unlike with RRSPs, there’s no age limit at which TFSA assets must be withdrawn. With an RRSP, you must convert your plan into a Registered Retirement Income Fund (RRIF) or an annuity by age 71 and begin withdrawing at least some of your savings each year.

The bonus here is that TFSA withdrawals will have no effect on income-tested benefits, like Old Age Security (OAS), that can be clawed back once you hit a certain income threshold – so you can avoid the equivalent of an additional 15% tax on the amount withdrawn.

There are also several other income-tested benefits and tax credits that are clawed back to varying extents, depending on your retirement income. For instance, having more TFSA income to work with may help you qualify for the age amount, a means-tested non-refundable tax credit offered to those aged 65 and older with an income below a certain threshold.

For Munro, thinking ahead and having a long-term financial plan – and putting it in writing – is the key to being able to take advantage of the money-saving potential that TFSAs offer. Making even small changes today can have a big payoff that occurs much later in life, she explains.

“We know the comprehensive financial planning available through qualified advisors leads to better decisions and greater financial security,” Munro says. “Just helping you to think through which of your investments should be held in which account, and in which order, can make a big difference in retirement.”

TFSA strategies to bolster your retirement

To further boost retirement savings, for instance, there may be an advantage to intentionally storing up RRSP room, and using a TFSA in the interim. Should your income jump, pushing you into a higher tax bracket, TFSA funds can be withdrawn to make an RRSP contribution, creating TFSA repayment room at the same time. This tactic might appeal to young professionals, for example, since their income generally jumps significantly after completing numerous years of training.

Similarly, if you’re a public service worker with a guaranteed pension, you’re really limited as to how much you can put into RRSPs to begin with, so the TFSA becomes a more viable retirement planning option, with potential contribution room growing by $6,000 every year, regardless of income level and available RRSP contribution room.

Looking to the long term

Many Canadians underestimate the remarkable earning potential of TFSAs, using them primarily for short-term savings goals. But looking a bit further down the road, it’s easy to see that a TFSA can also be a flexible tax-shielding option in retirement. Be sure to review your overall financial plan and determine where TFSA savings can help you the most.