TFSA vs. RRSP part 2: When is one plan better?
Posted 28 Nov 2014 by Rick Irwin, CFP, CLU
As we've discussed in Part 1, the "better plan" usually depends on your individual situation. But are there circumstances where one plan is clearly favoured over the other?
Short term savings
In general, the TFSA is a far better option to place short-term money as any tax benefit received from placing your money in an RRSP would be lost if you needed to prematurely withdraw the funds due to the tax paid on the withdrawal. If you are uncertain what the funds will be used for, especially if you are early in your career and expect to move into a higher tax bracket later on, the TFSA is likely your better first time savings vehicle. Another alternative would be dividing investments between the two programs to hedge your bets and still have some tax savings in the process.
It is often suggested that you can contribute to your RRSP and save the deduction for a future year where your income is higher – this strategy was commonly used prior to the introduction of the TFSA. The problem with this approach now is that the tax you will pay on the growth in the RRSP account between the time it is invested and the time it is deducted is wasted as that same investment would have incurred no tax if it had been contributed to a TFSA.
That said, sometimes using the TFSA as a rainy day fund can be a “waste” of the tax-saving power of a TFSA. This also depends on the amount of money involved: if you have a large sum of money outside of your RRSP it would be better to shelter the amount you would have earmarked for investments inside a TFSA and put the short term savings in a regular taxable bank account. The tax you pay (1.5% on a premium high interest account) is fairly minimal; therefore sheltering it via a TFSA has a diminished effect. If you don’t have enough funds to max out a TFSA through investing then it is OK to park short term funds there.
The one exception to using RRSPs as short-term savings vehicles would be the First Time Home Buyers Plan and the Life Long Learning plan, both of which allow you to use the RRSP as a savings tool to magnify the amount and expedite the window of time to achieve these goals through government tax breaks. For most Canadians, if they plan to save funds to buy a first home or to return to school, and they have the RRSP contribution room available, it makes more sense to use the RRSP to save for the goal as you and the government will be both be contributing. This might not be a valid strategy if your income is low, however.
Lower income individuals: Working years
If you are a lower income individual, for example on parental leave, a student, or in the early stages of a career where you expect an acceleration in earnings, it probably makes sense to forgo the RRSP contribution and use the TFSA as a savings vehicle instead. In fact, I generally advise to only consider making an RRSP contribution if the amount contributed is deducted against income that is taxed at a rate higher than the first tax bracket. Note: choosing the TFSA as a retirement saving vehicle requires greater discipline to maintain than an RRSP due to the lack of tax consequences to draw the funds early.
Eligibility for income tested benefits
Tip: Preserving Guaranteed Income Supplement
Specifically in regards to the guaranteed income supplement (GIS), which is an additional payment made to lower income of old age security (OAS) recipients, RRSP withdrawals can effectively be subject to a 72%-74% tax rate, depending on your province of residence, as you are not only taxed at the lower combined tax rate in that province (24% in Nova Scotia) but any taxable income, including RRSP withdrawals, reduce the GIS benefit by 50 cents on the dollar. For those individuals who would likely have only received a 24% tax break on their initial RRSP contribution, the RRSP can end up being a horrible way to save for retirement and those with modest RRSP savings may want to redeem their RRSPs and transfer them to TFSAs prior to age 65. Consulting with a tax professional is recommended.
If you expect to be a recipient of income tested benefits such as Old Age Security, the Guaranteed Income Supplement or GST credits, withdrawals from a TFSA won’t affect your income and may therefore preserve your benefits.
Often, the consideration to make an RRSP contribution is short term in nature (a phenomenon coined “Blinded by the Refund”) and one should really take a step back and consider all of the longer term ramifications before making a choice. When in doubt, especially if your income is low, the TFSA may be the better choice.
The next segment will talk about the psychological factors to be considered when deciding between an RRSP and a TFSA.