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TFSA vs. RRSP: Where Should You Put Your Money?

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Back in 2009, the Tax-Free Savings Account (TFSA) was introduced to Canadians.   Since then, TFSAs have grown in popularity, and as a result, there have been many great debates over the Registered Retirement Savings Plan (RRSP) and the TFSA. Let’s take a deeper dive into this debate to help you make the right decision.

RRSPs give you an immediate tax deduction

The most attractive feature of the RRSP is the immediate income tax savings you get when you make RRSP contributions. The value of this tax break is determined by the marginal tax rate that you are in. This short-term tax gain is offset by future tax pain when you take the money from the RRSP.  When you take money out, you have to pay tax based on your marginal tax rate at the time you take the money out (not based on the tax rate when you originally put the money in). Any growth inside the RRSP grows tax-deferred, but you will pay taxes when you withdraw the funds.

Related article:  Making the right RRSP decision with one formula

Tax-Free savings accounts are also tax-sheltered

Unlike the RRSP, TFSA contributions are not tax deductible. The main appeal of the TFSA is that you don’t have to pay income taxes when you take the money out. If you think about it, that’s not such a big benefit because the same thing happens with your bank account or any non-RRSP savings or investments with regard to your capital or principle). 

The benefit of TFSAs is the tax-free growth on your investment. You don’t pay income tax on any of the growth inside a TFSA.

Related article:  TFSA Basics: contributions and withdrawals

TFSA vs. RRSP: Comparing the Tax

Examining the tax treatments of RRSPs and TFSAs is one of the best ways to compare the two accounts.

Before tax income $1000 $1000 $1000
Income tax (30%) $300 $300 $0
After tax contribution $700 $700 $1000
Value after 25 years (6% growth) $3004 $3004 $4292
Income tax at withdrawal (30%) $601 $0 $1287
Net withdrawal after tax $2403 $3004 $3004

In this example, the result is that the TFSA and RRSP are very similar when the marginal tax rate is the same (30% in this example) when the money goes in and when the money is withdrawn. Note:  The tax calculated under the non-RRSP column assumes no tax efficiencies.

The tax could be lower if dividend or capital gain is taken into account.

In the following example, there is a mathematical edge to the RRSP if the marginal tax rate at the time of withdrawal is less than the marginal tax rate at the time of contribution:

Before tax income $1000 $1000 $1000
Income tax (30%) $300 $300 $0
After tax contribution $700 $700 $1000
Value after 25 years (6% growth) $3004 $3004 $4292
Income tax at withdrawal (25%) $501 $0 $1073
Net withdrawal after tax $2503 $3004 $3219

If, on the other hand, the marginal tax rate at the time of withdrawal is greater than the marginal tax rate at the time of contribution, then the TFSA has the advantage:

Before tax income $1000 $1000 $1000
Income tax (30%) $300 $300 $0
After tax contribution $700 $700 $1000
Value after 25 years (6% growth) $3004 $3004 $4292
Income tax at withdrawal (35%) $701 $0 $1502
Net withdrawal after tax $2303 $3004 $2790

Remember that every example you find on the web is based on a set of assumptions for illustrative reasons only.  It’s important to apply the process to your own circumstances, and numbers using your own assumptions that you think are best suited for you.

Other factors

While tax creates an opportunity to compare the different accounts mathematically, other issues will impact your decision in choosing RRSP or TFSA.

What is your investment objective?

If you are saving to spend money in the near or mid-term, like saving for a car, a kitchen renovation, or maybe a vacation, I think we can all agree that the TFSA is a better option because using the money does not trigger the tax.  However, putting money into a TFSA and then taking out on a regular basis kind of defeats the real benefit of a TFSA and that is the long term TAX FREE growth.  Constantly taking money out of the TFSA can be a big hurdle to growth. If you think about it, you be better off using a savings account outside of a TFSA to accomplish the same thing (especially when interest rates are really low).

Emergency Funds

Most people will agree that a TFSA, conceptually, can be a great place for emergency money.  However, you can also argue that an emergency fund should be not only readily accessible but also safe.  Putting safe investments with lower returns can also negate the true benefit of tax-free growth, so non-RRSP savings may be a better alternative for emergency funds over the TFSA.  That way, you can use your TFSA to invest more for growth.

Related article:  Investing options for the TFSA

Saving for your first home or education

While the TFSA and the non-RRSP are logical ways to save for a home or education, the RRSP does offer two opportunities to withdraw money through the First Time Home Buyers Plan and the Lifelong Learning Plan.

Saving for retirement

If you are saving for retirement or the longer term, the math presented earlier can be pretty helpful in making that decision. Understanding the differences in tax treatment is quite important in the debate.  

Saving for growth

Personally, I use my TFSA to save for maximum growth. Remember that one of the biggest advantages of the TFSA is tax-free growth. I maximize my TFSA every year, and if I could put more into the TFSA, I definitely would. 

My TFSA is with Questrade, and I intentionally put all my growth-oriented investments into the TFSA. Ideally, I would love my TFSA to be my biggest account because it is a tax-free asset (which is why the government imposes contribution limits).

Related article:  Questrade review   

They’re not mutually exclusive

One of the problems with the outcome of the TFSA or RRSP debate is it seems people have to choose between one or the other, which is not the case. Both the TFSA and the RRSP have merits. Is one really better than the other?

Both the TFSA and the RRSP have strong financial benefits.  My wife is a dietitian, and if I were to ask her which is better to eat, carrots or broccoli, she would tell me, “you should have them both in your diet.” 

She could get really analytical about the nutritional content of each, but in the end, they are both good.  I would say the same about TFSAs and RRSPs: both are good for you. We can analyze the tax merits one way or another, but let’s face it, they both have strong merits.  One way to invest in both the RRSP and the TFSA is to invest in the RRSP first and then use the tax refund put it into the TFSA. Here’s an example:

Let’s say you have $5,000 to invest. You could put the entire $5000 into the TFSA and be really happy about a liquid tax-free account.

On the other hand, you could put $5000 into the RRSP, which will generate tax savings based on your marginal tax rate. Assuming a marginal tax rate of 35% translates to a tax savings of $1750. You could then take the $1750 of tax savings and put that into an investment in the TFSA.

Essentially, you now got $6750 of use out of $5000. Let the government contribute to your TFSA so you can get more money working for you.

Not sure which is better? Start with the TFSA

Many people really like the flexibility you have in the TFSA. If you put money into the RRSP, you can’t get the money out without tax consequences. That also means you can’t move the money to the TFSA without paying the tax if you decide later that was a better course of action.

On the other hand, if you put the money into the TFSA, you can always move the money to the RRSP later without tax consequences. As many of the experts above have pointed out, this may be ideal when you are younger and just starting out or in a lower tax bracket.

On the flip side, I like TFSAs a lot, and I think they have great merit, but sometimes, I think they are too easy to access.  If you are not very disciplined, sometimes putting money into RRSPs helps prevent you from taking it out in the future.

Don’t pass up free money

If you have access to a Group RRSP through work and the employer matches contributions, I call this free money.  In this case, always choose the RRSP before the TFSA.

Related article:  Group RRSPs:  Are you missing out on Free Money?

“Better” is personal

All financial planning is personal. Just because the average Jane thinks TFSAs are better than RRSPs does mean that applies universally to everyone, especially you. Just because I say I like the RRSPs better for me does not mean you should blindly follow my personal strategy. Here are three rules of thumb to help you analyze your personal situation to make good decisions

  1. Use my one-formula approach. If your marginal tax rate at the time of contribution is greater than your marginal tax rate at the time of withdrawal, then the RRSP makes sense.
  2. If you are not sure which way to go, the safer course of action is to buy the TFSA because it gives you the most flexibility in the future.
  3. If you can, do both. They are both great financial accounts, so the ideal strategy is to have both. One way to do that is to buy the RRSPs first and get the government to put money into the TFSA for you.

RRSP or TFSA: Final thoughts

I will finish off here by outlining some of the other rules of the RRSP and TFSA, which may be relevant when choosing between RRSPs and TFSAs

  • For the TFSA, you have to be over 18 to accumulate contribution room. With RRSPs, you start to accumulate contribution room as soon as you start working and file a tax return.
  • TFSA limits are set annually by the government. Everyone has the same limit.  RRSP limits are based on your previous year’s taxable income, so everyone can contribute different amounts to the RRSP.
  • You do not lose your contribution room if you don’t contribute to a TFSA. It carries forward into the future.  The same applies to your RRSP.  Both your RRSP and TFSA limits are tracked by CRA.
  • Once you reach age 71, you can no longer contribute to an RRSP unless you have a younger spouse and contribute to the spouse’s Spousal RRSP. There is no upper age limit for TFSA.  My 91-year-old father still contributes to a TFSA.
  • Both the TFSA and the RRSP offer the same options for investments. You can invest in savings, GICs, bonds, mutual funds, Exchange Traded Funds, stocks, etc.
  • If you take money out of a TFSA, you can put it back in, but you must wait until the next calendar year to do so. If you take money from your RRSP, you cannot replace it unless you have unused contribution room.  Any money you put into an RRSP uses up your contribution room.
  • TFSA investments grow tax-free. RRSP investments grow TAX DEFERRED.
  • For both the RRSP and the TFSA, you can name a beneficiary. If you have a spouse, there are tax benefits to naming your spouse as a beneficiary on the RRSP and as a Successor Annuitant on the TFSA.

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