An exciting event is coming up in my group of old friends: another one of us is approaching Early Retirement.
Mr. Frugal Toque, whom you may recognize from his many comments and occasional guest posts on this site, is a software engineer in his mid-thirties living in the high-tech belt of Ottawa, Canada. We survived the trenches of engineering school together in the 1990s, then got jobs just a few cubicles apart in the same big company after graduation. When I greedily took off to the United States in 1999, we inadvertently became a financial science experiment.
Certain key variables were kept constant: age, education, health, industry, graduation date, etc. And others were varied: I moved to a country with slightly higher salaries and lower taxes, while Toque got married and went to a single-income household a bit earlier, had two kids instead of one, didn’t make money on the side through buying and selling houses, and built up a slightly more expensive luxury compound in the woods for himself.
But financial independence is not a yes-or-no concept. Instead, it’s just a matter of time, and here he is roaring towards the finish line with a solid 65 years of freedom to look forward to. The mortage is just about crushed, and the retirement savings accounts have been maxed out every year for well over a decade. Depending on windfalls, I’m guessing he will be independent within the next 18-24 months.
So this past summer, I challenged him to brush up on his Canadian investing and tax skills, since with he will soon be living off of rather than rapidly accumulating investments. And with Canada being the second largest source of readers, I figured his teachings are well worth a few weekend editions. This is a guy who tends to kick ass at anything he takes up, so I think we’re in for some good learning. First Edition Below.
Oh, Canada! How shall I retire!
(RRSP versus TFSA)
I know that my country has a pretty bad rep when it comes to taxes. I stopped complaining about that sort of thing more than a decade ago when I realized the place has done pretty well by me and I understand that this costs money.
On the other hand, if you’re living in the U.S., you might have a very negative attitude about Canada where taxes are concerned. As a Canadian you might be one of those lamentable few who says that the Mustache family was only able to achieve its goals by moving south because taxes in the Great White North make it impossible here.
I’m here to tell you that this is nonsense, you have a case of Excusitis and are a Complainypants.
First of all, the income tax system is progressive – just like anywhere else – and a good chunk of the money you save in registered accounts won’t get taxed at the top marginal rate.
In Canada we have two major, easy to use options for growing our savings without the burden of taxation:
- the RRSP (Registered Retirement Savings Plan)
- and the TFSA (Tax Free Savings Account)
We’ll tackle the RRSP first, because it’s fated to be the road first traveled by a proper Mustachian (more on why in a moment). If you are earning money, you should have an RRSP account with your bank. Every Canadian bank I’ve checked requires you to actually visit a physical branch office and set up this account. For legal reasons, they need to personally assess your financial knowledge and have you sign certain forms. Some of this work can be done over the phone or the Internet, and rules are changing all the time, but you probably still need to do at least one physical visit.
How RRSPs Work
The money you put in to an RRSP account does not count as income for the year in which you make the deposit. This isn’t one of those lame “tax deductions” where you get 15% of the money back at tax time even though your marginal tax rate is 37%. No. The money you put in an RRSP, which is up to 18% of your previous year’s income, does not count as income at all. If your employer supports it, the tax will actually be deducted at source, so you don’t have to wait until March to get your refund.
That’s right. You can literally take 18% of your income  and dodge those terrible Canadian taxes you hear about!
Yes, you do. You pay taxes on them when you withdraw, during your retirement. Consider this though. You’re a Mustachian. That means you can support a family of four in luxurious style on about $24 000/year after housing expenses. If you arrange your finances correctly, dividing up your retirement funds with a spouse, the two of you will be in the lowest possible income bracket and end up paying almost no income tax.
That’s right. No income tax! In Canada! The law even allows you to put your money in a “Spousal RRSP” no matter how much your spouse earned. Your spouse withdraws this money during retirement as his or her income, not yours.
Where does the TFSA come in?
Alright. You’re frugal. You’re even wise enough that you set up automatic paycheque deductions so you don’t have to think about your RRSPs. You’ve already paid off your mortgage because you hate debt so much. So now you have even more money you want to ‘stash away. What comes next?
Enter the TFSA. Whereas the RRSP took pre-tax income, skipped over paying taxes, and required you to pay taxes on withdrawal, the TFSA works in the other direction. The TFSA is where you put after-tax income. The money can then grow, tax-free, inside the TFSA and will not be taxed when you withdraw. How much money can you put into TFSAs? It started at $5000 per year and is now up to $5500 per year. It accumulates over your lifetime starting when you turn 18, but the concept was only invented in 2009, so no matter your age, your accumulation can’t start before then.
RRSPs: you put pre-tax income in, it grows tax free, you pay taxes on the way out. (just like 401(k)s in the US)
TFSAs: you pay taxes before you put it in, it grows tax free, you pay no taxes on the way out. (Just like Roth IRAs in the US)
Now why will readers of this blog prefer the RRSP over the TFSA? Why am I doing that one first?
For the simple reason that a Mustachian is, by definition, a person who has expenses far, far below his or her income. What matters with an RRSP is the difference in tax rates between when you put money in and when you take it out. Thus, you’re in a relatively high bracket while you’re working and you’ll be in a relatively low tax bracket when retired.
Example: RRSP Benefits
Let’s take a wage earner in the province of Ontario who earns exactly $100k. We’ll say she’s a high tech worker with over a decade of experience, or maybe a high level executive manager of some manufacturing company. She has a non-working spouse, two children and no other deductions.
If she decides to put no money in her RRSPs, she ends up paying tax on her full income, amounting to $15 403 in federal taxes and $8 558 in provincial taxes.
If, instead, she decides to max out her RRSP contribution at $18000, she gets $18000 in her RRSP investment account and lower her taxes to $10928 federal and $5662 provincial.
Her total income taxes went from $23962 down to $16590, a change of $7372.
What this means is that she took back over seven thousand dollars that would have gone to the government and stashed it away. Another way to look at this is that it cost her $10628 to get $18000 in savings. Fabulous!
And again we’re back to the complaint from earlier. Won’t she have to pay taxes when she retires? Of course she does, but she’ll be paying it at much lower tax rates.
Let’s assume she’s living on $24000/a, a perfectly reasonable level of expenses, and plug that into the formula. We get federal taxes of $147 and provincial taxes of $439. So she can either have $17600 in her investment account, which will grow tax free inside her RRSP, or $10700 outside her RRSP, which will be taxed as it grows. You make the call. And before you do, add in the interest. You’ll find it just as relevant as it always is.
This is why Canadian Mustachians love RRSPs.
While my understanding of American financial issues isn’t all that strong, I hear a lot about “early withdrawal penalties” in the U.S. I can not find any sign, on any government or bank website, that this is an issue in Canada. While there are some rules about disposing of your RRSPs when you turn 71, we’re talking about early retirement here, so that shouldn’t be an issue. The only real concern you have is that you ought not to withdraw money from your RRSP accounts in the same year that you had work income. If you do that, the RRSP withdrawal will naturally be taxed at a high marginal rate, since it will be added to whatever you earned that year.
So retire in December and don’t take anything out until January.
Priorities: RRSP, TFSA, Mortgage
Presuming you have a mortgage, an RRSP account and the ability to save in TFSAs, your priorities (logically) ought to be:
- RRSP first
This assumes your mortgage is at a lower rate than the the 7% average you might expect from a stock index fund.
If, for some reason, your mortgage is up closer to 5%, you might consider the short term, reliable gain of killing the mortgage instead of saving in the TFSA. You’d still want the RRSPs to go first though, because they give you so much back on your income taxes.
The TFSA as a rainy day fund:
The strategy might change slightly if you have unstable work. You might be a seasonal worker, or in an industry that doesn’t reliably keep you employed. In that case, you might consider placing a higher priority on the TFSA. It is slightly easier to take money out of your TFSA than your RRSP, so having money in the TFSA is very much like having one of the those “rainy day” accounts that some financial bloggers go on about. You would still max our your RRSP, but prioritize your TFSA over making extra mortgage payments.
Last of course, are the hard core debt-haters like your very own Mr. Frugal Toque. Even though my mortgage is under 4%, I want that sucka dead. I want to dance a jig on its grave while pounding back a shot of throat-scouring whiskey. So my own priorities are
… although we keep some money in a TFSA for emergencies. 
The point of all this is that Canada is actually a very good friend of early retirees. The RRSP and the TFSA, with their attendant tax benefits, are very useful tools. How you use them and how you prioritize them, are obviously up to you. But whether you believe in rainy day funds or not, the tools are there waiting for you.
In my next column, I’ll discuss where we can actually put our money and compare the various mutual funds available and the corporations that offer them.
2013 federal and provincial tax rates:
Revenue Canada’s TFSA website:
 – If you don’t use the entire 18%, don’t worry, it rolls over and you can use in any later year. But you may sense a Withering Glare coming at you over the Internet. That’s me, wondering what the hell you’re doing saving less than 18% of your income.
 – To be honest we keep about four month’s expenses in a TFSA, even though the mortgage isn’t done. As you know, I’ve been laid off once before and the TFSA is a nice way to reserve money for such emergencies while also keeping it employed. It is in a proper Stock Index fund, not one of those “safe” money market funds, so technically it’s making a better payoff than my mortgage anyway.
 = Sneak Preview: In my research, I learned that President’s Choice Mutual funds blow. They’re just repackaged %ges of CIBC mutual funds. So you can’t actually get a Canadian Stock Index Fund, you get a series of Int’l mutual funds, all pre-packages in certain ratios. And you pay a 0.95% to 1.15% expense ratio for that privilege.