TFSA vs. RRSP Part 1: Which Plan is Best?

Posted 21 Nov 2014 by Rick Irwin, CFP, CLU

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There are many financial decisions before us as Canadians—do we pay down mortgage debt or invest in RRSPs? Take out a high-fee credit card with a loyalty program or a low-fee basic card? Which investment options should we choose to meet financial and retirement objectives? One of the more recent financial decisions, which we are often asked about, is which investment vehicle is the better choice, a TFSA or an RRSP?

First, a few basics about each plan:

 

RRSP

TFSA

Contribution limits

RRSP contribution limits can be found on your most recent Notice of Assessment or the “My CRA” website. The RRSP contribution limit is an individual calculation and in any given year it is the sum of any carry forward RRSP contributions you have from previous years, plus the RRSP contribution limit you earned in the previous year (18% of earned income less any adjustment for pension contributions)

TFSA contribution limits have to be tracked manually or can be found on the “My CRA” website. The TFSA contribution limit is universal for all Canadians who file a tax return. Currently it is $5,500/year and $31,000 in total (for 2014 for someone who has not made any TFSA contributions currently)

Deductions of contributions

RRSP contributions are tax-deductible against income

TFSA contributions are made with after-tax income, contributions are not tax-deductible

Taxation of earnings while inside the plan

Both plans provide tax-free growth inside the plan

Withdrawals

RRSP withdrawals are taxable at the individuals’ marginal tax rate in the year they are withdrawn

TFSA withdrawals are tax free

Re-contribution of withdrawals

RRSPs do not allow re-contributions; the only way to build new RRSP contribution room is to have earned income in a subsequent year

Withdrawn amounts from a TFSA get added to your contribution room the following year

Forced withdrawals

RRSPs have to start to be collapsed into a Registered Retirement Income Fund (RRIF), at a prescribed government set rate at age 72

There are no forced withdrawals of TFSA investments

As for the decision on which plan is the better solution for your saving and investment goals, the answer is simple: it depends. The factors here are both psychological and taxation related. Ignoring the psychological factors for now (we’ll look at these in a future article), the fundamental tax consideration for which plan to choose is based on what your marginal tax rate is today (what tax bracket you are in now) versus what your expected tax rate will be when you start to take the money out of the plan. For the purpose of this analysis we are assuming that this is a long-term investment and the withdrawal will occur in retirement. We will discuss short-term time horizons in the next article.

The basic rule of thumb is this: if you expect to have a higher marginal tax rate today than in retirement, meaning greater tax saved on the RRSP contributions versus the tax paid on the withdrawal, the RRSP will provide the greater total financial benefit. If you expect to be in a higher tax bracket in retirement than when you made the contribution, the TFSA will offer the better outcome. If your tax bracket is expected to be the same in retirement as when the contribution is made, both plans will offer exactly the same outcome regardless of age, time horizon or investment returns.      

Hopefully this has shed some light on the basics of each plan type. The next segment will talk about specific situations where one plan may be more applicable than the other.