Choosing between the RRSP and TFSA

Choosing between the RRSP and TFSA
Written by Camillo Lento

Many Canadians are finding that they do not have enough disposable income to make the maximum contribution to both their TFSA and RRSP.  This situation leads to an important decision: when faced with limited funds, should you contribute to a TFSA or RRSP?

Tax Neutrality
Before analyzing the details, it is important to understand that a TFSA and RRSP may be tax neutral.  That is, a TFSA and RRSP may yield the same investment result.  A simple example will illustrate this result.  Consider an individual who earned pre-tax employment income of $1,000, a marginal tax rate of 25%, and an investment returning 5% annually.  The individual can invest the entire $1,000 pre-tax income in the RRSP or the after-tax income of $750 in the TFSA.   Table 1 presents the resulting after-tax dollars of investing for 10, 20, and 30 years.

RSSP

TFSA

Annual
return
($1,000 to start)
Taxes
After-tax
dollars

Total after tax dollars ($750 to start)

Difference
Value of contribution in
5%
25.00%

5%

10 years
1,628.89
407.22
1,221.67

1,221.67

20 years
2,653.30
663.32
1,989.97

1,989.97

30 years
4,321.94
1,080.49
3,241.46

3,241.46

Table 1 reveals that when the rate of return is held constant (5%), and the marginal tax rate at the time of contribution to, and withdrawal from, the RRSP are constant (25%), there is no difference between the TFSA and RRSP.  This is tax neutrality.

Tax Neutrality = Decision Irrelevance?
The fact that the TFSA and RRSP can be tax neutral does not mean the decision is irrelevant.  Firstly, an individual’s marginal tax rate varies from year-to-year, and it is unlikely that it will remain constant over a ten to thirty year period.  Secondly, there are other factors that need to be considered.

Varying Marginal Tax Rates
One of the most important considerations in deciding between the TFSA and RRSP is the marginal tax rate at the time of contribution and withdrawal.  An RRSP becomes optimal when an individual’s marginal tax rate is greater at the time of contribution than at the time of withdrawal.  Consider the same example as above, except that the marginal tax rate at the time of contribution is 25% and 15% at the time of withdrawal.  Table 2 presents this analysis.

Annual
return
(Start with $1,000)
Taxes
After-tax
dollars

Total after tax dollars
(Start with $750)

Difference
Value of contribution in
5%
15.00%

5%

10 years
1,628.89
244.33
1,384.56

1,221.67

162.89

20 years
2,653.30
397.99
2,255.30

1,989.97

265.33

30 years
4,321.94
648.29
3,673.65

3,241.46

432.19

Conversely, the TFSA is optimal when an individual’s marginal tax is less at the time of contribution than at the time of withdrawal.  Table 3 presents the analysis when the marginal tax rate at the time of contribution is 25% and 35% at the time of withdrawal.

RSSP

TFSA

Annual
return
(Start with $1,000)
Taxes
After-tax
dollars

Total after tax dollars
(Start with $750)

Difference
Value of contribution in
5%
35.00%

5%

10 years
1,628.89
570.11
1,058.78

1,221.67

-162.89

20 years
2,653.30
928.65
1,724.64

1,989.97

-265.33

30 years
4,321.94
1,512.68
2,809.26

3,241.46

-432.19

Considerations when Estimating Future Marginal Tax Rates
On first glance, an individual may automatically assume that their marginal tax rate will be lower at retirement than during their working years.  You may conclude that your marginal tax rate will be lower at the time of withdrawal than at the time of contribution, and that the RRSP is optimal.

Many times, this may be the case.  However, consideration should be provided to the fact that withdrawals are treated as taxable income.  A person who withdraws funds from the RRSP at retirement needs to consider three income related clawbacks to their Old Age Security, the Guaranteed Income Supplement, and the age tax credit.  The tax policy associated with the clawbacks is that those individuals who enjoy higher levels of taxable income do not need the benefit of this tax relief.  Accordingly, higher tax rates are imposed on those seniors who earn significant taxable income.

Consideration the Reason for your Savings
It is also important to consider the purpose of your savings.  The TFSA is much more versatile in terms of savings for other than retirement because withdrawals from the TFSA can be re-contributed in a future year.  This varies from the contribution room calculations for an RRSP which prohibit an individual from re-contributing the withdrawn funds from an RRSP.  A TFSA can be used more freely to save for shorter period of time, such as saving for a car, home extension, vacation, etc., whereas an RRSP is more geared towards saving for retirement.

Conclusion
Overall, the TFSA versus RRSP decision will depend on your individual circumstances and the purpose for your savings.