Planning for retirement used to be easy. You contributed to the Canada Pension Plan because you had no choice and this was done automatically through payroll deductions. If your employer offered a pension plan, you wisely participated. And if there was any money left over, you contributed to your RRSP, up to an annual maximum.
Then came the TFSA account in 2009. Suddenly, a choice had to be made: Should you contribute to your RRSP, your TFSA or both?
Let's start by comparing these two savings vehicles face to face in a few ways:
With the RRSP, you get to deduct any contributions that you make in any given year from that year's income. That means that you get to pay less tax at tax time in April of the following year.1
If you are lucky, you may even get a refund when you file your income tax return. With a TFSA, you get no such deduction or refund.2
However, when it comes time to withdraw money, you will be taxed on any money you withdraw from your RRSP (at whatever tax rate is prevailing in the future when you make the withdrawal and at whichever marginal tax rate you happen to find yourself in). With the TFSA, you pay no taxes upon withdrawal2
Some people think that the TFSA is the clear winner when it comes to taxation. Why, they ask, would you want to share your investment gains with the government in the future with an RRSP when you could get to keep one hundred percent of your investment gains if you invest using a TFSA?
The problem with this type of thinking, is that it is incorrect. It is an illusion that you get to keep more of your investment gains with a TFSA. The TFSA and the RRSP are in fact mirror images of each other when it comes to taxation. Whether you pay the tax now or in the future makes no difference to how much you get to keep. The best way to demonstrate this is with an example:
John earns 100 000 dollars per year. His marginal tax rate in 2014 would be 43.41%3
(assuming this was all regular income from wages). If he contributes 5000 dollars to his TFSA, he gets no income tax refund at tax time in April. Now, assume an annual rate of return of 10% on his investment. At that rate of return, John's 5000 dollars has blossomed into roughly 8000 dollars after 5 years. This is a total investment gain of 3000 dollars (8000 minus 5000 = 3000 dollars). Five years later, John can now withdraw that 8000 dollars tax free and go purchase a brand new 50 inch flat screen plasma TV. He pays no tax on that 8000 dollars and gets to keep it all for himself. Not bad, right?
Now, let's look at what would happen if John contributed that 5000 dollars to his RRSP. Assuming the same rate of return, John can withdraw his 8000 dollar gain 5 years later. Unlike with the TFSA, this withdrawal is not tax free and John will have to pay taxes on that withdrawal at his full marginal tax rate of 43.41%. That means he has to fork over 3472 dollars to the government and is left with 4528 dollars (8000 minus 3472 = 4528 dollars). Sound like a bad deal, right? Who wouldn't rather have 8000 dollars (as with the TFSA) instead of only 4528?
What we are forgetting about is the tax refund that John received when he contributed the five grand to his RRSP. At his marginl tax rate of 43.41%, john would have received a tax refund of 2170 dollars for making that contribution. He can then invest that 2170 dollars outside of his RRSP and earn the same 10% annual rate of return on that money for five years. Five years later, that non-registered investment would be worth about 3494 dollars.
He now has $4528 after raiding his RRSP plus $3494 for a total of, you guessed it, about 8000 dollars.
So in both situations, John ends up with the same amount of cash! 8 grand in his pocket, with which he can go buy a nice plasma flat-screen TV.
What we have not considered in the above example is what would happen if John's tax rate was lower at the time of his withdrawals as compared to when he was contributing to these savings vehicles. If he is earning less in retirement than when he was saving up his money, the RRSP will provide a greater after-tax return. If, on the other hand, he earns more in retirement and gets bumped up to a higher marginal tax rate, the TFSA will provide a greater after-tax total return.
It is also important to consider that if John decides to spend his tax refund of 2170 dollars instead of investing it outside of his RRSP (as may be tempting to do when he receives the cheque in the mail), this math will not work and he will, in fact, end up with less money by going the RRSP route.
i) If your marginal tax rate is the same now as it will be when you are making withdrawals, there is no difference between the RRSP and the TFSA when it comes to taxes. They are, in fact, mirror images of each other.
ii) If your marginal tax rate is going to be higher in retirement than it is today, the TFSA is a clear winner.
iii) If your marginal tax rate is going to be lower in retirement than it is today, the RRSP is a clear winner.
Most people will likely be in a lower tax bracket when they retire as they will not be earning as much money. Therefore, for most people, the RRSP may be a better choice when it comes to saving money on taxes. However, it is difficult to predict how much money you will make in the future and it is always possible that our chronically cash-strapped governments will raise taxes in the future to pay off our massive public debts, which would tilt the favour towards the TFSA.
2) Size of your account
How much you can contribute to an RRSP and a TFSA is calculated differently.
In a TFSA, you can sock away 5,500 dollars per year.2
This contribution room begins to accumulate at the age of 18 and does so regardless of how much income (if any) you are earning.
In an RRSP, you can sock away 18%4
of your earned income to a maximum of 24 270 dollars (in 2014)5
Therefore, if your income has been, on average, greater than about 30 grand a year since you were 18 years of age, you will likely have a higher RRSP contribution limit as compared to your TFSA contribution limit.
For most people, the RRSP contribution limit will likely far exceed the TFSA contribution limit. In other words, they will be able to put away more money in an RRSP than they can in a TFSA.
3) Types of investments
Generally speaking, both accounts can hold the types of investments that most of us would consider owning. For example, you can hold cash, GICs, stocks, mutual funds and bonds in both an RRSP and a TFSA.6,7
One difference: Although you can hold your own mortgage within your RRSP (and pay your mortgage interest to yourself), it is prohibited to own an investment to which you are closely related inside a TFSA (including "debt of the holder", which would include your own mortgage!).8
The RRSP has a slight edge when it comes to the variety of investments you can hold.
When it comes to flexibility, the TFSA is clearly superior.
With the TFSA, any withdrawals you make can be added back the next year.9
For example, if you take 3000 dollars out of your TFSA to fix a leaky roof on July 15 2013, you can put that 3000 dollars right back in anytime on or after January 1, 2014.
With an RRSP, you cannot later re-contribute any amounts withdrawn (except under some special circumstances such as the Home Buyer's Plan or the Life Long Learning Plan). The contribution room is lost forever.
These differences make the RRSP suitable only for long-term retirement saving, while the TFSA could be used for many other purposes such as an emergency fund or saving to purchase an item like a car.
The TFSA is clearly more flexible than the RRSP.
The TFSA can be with you forever if you choose to keep it open.
With the RRSP, on the other hand, you are forced to make a decision when you turn 71. At that time, you can either close the account and withdraw all of the funds (subject to a withholding tax, of course), start withdrawing from it (at a minimum rate via an RRIF) or convert it to an annuity.10
This makes the TFSA great for long term investments, as you will never be required to liquidate them if you choose to hold forever. It also makes the TFSA a good savings option for those who are older than 71 and can no longer legally keep an RRSP.
The TFSA clearly can be kept for longer than an RRSP.
6) Effect on income based government programs
When you withdraw money from your RRSP, it is included in your income for the year in which you withdrew it. With many government programs such as Old Age Security and the Guaranteed Income Supplement being means tested, this extra income can either make you ineligible for such programs or reduce the amount of money you are eligible to receive.
Withdrawing from a TFSA has no such effect on the money that you can receive from these government programs.
The TFSA is better at protecting your eligibility for income based government programs such as Old Age Security and the Guaranteed Income Supplement.
- The Bottom Line -
As you can see, the best choice depends on your own particular circumstances and is not always clear.
We believe that the TFSA has a slight advantage over RRSPs: it is more flexible with respect to withdrawals, never needs to be closed and does not affect your ability to qualify for means-tested government assistance programs that are provided to seniors. It moreover provides the same level of tax sheltering as RRSPs for those who will be in the same tax bracket now and in retirement and can hold most of the same investments that the RRSP can hold. It will also allow those who cannot resist spending their RRSP refund cheque to save more money.
Therefore, unless you know for sure that your income in retirement is going to be significantly lower than it is now, we believe that the best choice for most people will be to first contribute to a TFSA. Once the relatively small contribution limit is reached, additional funds can be directed to an RRSP.