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TFSA or RRSP?

Planning1

Life used to be simple.  RRSPs were the only way to go because everyone said so — your TV, your advisor, your bank, and even your relatives.  Today, there’s a new ‘kid on the block’ and the $64,000 question is whether to invest in a TFSA or RRSP.

Since 2009, advisors recommend that we max out both our RRSPs and TFSAs.  That’s wishful thinking, as most of us have to prioritize, such as what new vehicle or flat screen TV to focus on buying next.

When you make a RRSP contribution, that amount is deducted from your taxable income and grows tax free.  But any time money is withdrawn, it is fully taxable.  Many Canadians don’t fully grasp this last point.  Net worth statements usually list the full value of one’s RRSP on the assets side, with no corresponding tax owing amount on the liabilities side.  You may have $150,000 in your RRSP today, but your silent partner CRA is patiently waiting for their share.  If you are in the top marginal tax bracket, in Alberta at that would be $58,500!

A TFSA is the mirror image of an RRSP, as you contribute after-tax dollars with no deduction for your contribution.  But once the money is in the plan, it not only grows tax-free, but can be withdrawn tax-free as well, so no tax ever!

RRSPs work well if your marginal tax rate is higher at the time of contribution, and lower when withdrawn.  Conversely, if the marginal tax rate is higher at the time of withdrawal than at time of contribution, TFSAs win, or so it seems!

Easy, right?  You just need to guess what your marginal tax rate will be at the time of withdrawal.  Lots of luck with that guess!  Plus when you withdraw money from your RRSP, not only do you have to pay taxes on it, but the increased income could also lead to a claw-back of your Old Age Security, Guaranteed Income Supplement or other means-tested income streams.

Based on various assumptions, TFSAs win over RRSPs a surprising percentage of the time and for most low-income earners, it’s better under the majority of scenarios.  But there’s no simple answer as to which is best.  So sit down with your advisor, as they will at least have the advantage of being able to customize their assumptions to your individual situation.

The big advantage of TFSAs is their flexibility, as you can take money out at any time and then put it back in future years.  But when using TFSAs for retirement savings, some will be tempted to dip into their plans for that trip with the intention of replacing it next year, but will they?  Many don’t have the fiscal discipline.  It’s tough enough to find cash for new contributions, let alone replacement money.  And even if the money is re-contributed, the lost growth is gone forever.

Some tips:  Don’t spend your RRSP refund, put it in your TFSA to grow tax-free.  Try to save more.  Don’t blow your TFSA money.  Don’t let the promise of a tax refund tempt you into borrowing to invest in an RRSP.  The interest is not deductible.  RRSPs are for retirement, not a piggy bank for trips or things.  Build up a TFSA rainy day fund for emergencies and those rare “opportunities”.

Thanks to David Chilton (“The Wealthy Barber”) for the original article this is based on.   
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