FP Answers: Should I invest in a TFSA or RRSP? And when does it make sense to do both?


Whether you make less than $45,000 annually, or more than $220,000, there are some key points to keep in mind when deciding where to put your money

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By Julie Cazzin with Allan Norman

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Q: This is the time of year when I always look at the money in my savings account and try to determine if I have enough to make a registered retirement savings plan (RRSP) or a tax-free savings account (TFSA) contribution. With two kids and a mortgage, money is often tight and I can only do one or the other. How do I go about deciding which is best for me? And if I ever have enough money to do both — something that will likely happen shortly after my mortgage is paid off — does it make sense to do so? — Leona

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FP Answers: That’s a good question, Leona, and I know from experience that a lot of people have this conundrum. But it all starts by understanding the math. There are other factors involved, but knowing the math will take you a long way toward making your decision.

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Before we get to the math, remember an RRSP contribution is before tax and withdrawals are taxable, while a TFSA contribution is after tax and withdrawals are tax free. This is an important distinction, as you will see shortly.

Also, an RRSP provides you with a tax refund, which you should think of as an interest-free loan that is yours to do with what you like, but has to be paid back when you withdraw from your RRSP or registered retirement income fund (RRIF).

Now, to the math.

The accompanying table compares the after-tax results of investing in an RRSP against a TFSA investment earning five per cent over 20 years. Which investment account do you think will do better, assuming your marginal tax rate (MTR) remains the same?

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The answer is in row six: If your MTR remains the same and both accounts earn the same rate of interest, there is no difference between investing in an RRSP or TFSA.

Row seven shows that if you have a lower MTR at the time of withdrawal than when you contributed, the RRSP beats the TFSA. Many people will find themselves in this situation when they retire or if they are part of a couple and are able to pension split.

Row eight shows the opposite. If your MTR is higher at the time of withdrawal than at the time of contribution, then the TFSA is better.

Row nine more likely represents most people’s estate taxes. In Ontario, your MTR is 53.53 per cent if you have a taxable income or estate of more than $220,000. Just a reminder that not all income is taxed at 53.53 per cent — only the income over $220,000.

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To avoid the large tax bite, it may make sense to draw surplus income from your RRIF even if you don’t need it to support your lifestyle. That shouldn’t be a problem if your MTR was 40 per cent at the time of contribution and it is 40 per cent at the time of withdrawal. The math says it is no different than if it was a TFSA investment (though the Old Age Security (OAS) clawback may be an issue).

The problem is you need another investment tax shelter. If you are drawing surplus income from a RRIF then presumably you don’t need it — it is surplus. If you have children or grandchildren, consider contributing to their registered education savings plans (RESPs), TFSAs or RRSPs.

That is the textbook explanation of the RRSP math, but let’s get realistic.

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Notice in row three that the RRSP investment was $7,142 (which is before tax) and the TFSA investment was $5,000 after tax. That is the proper way to do the comparison, but is that how most people invest? If you have $5,000 to invest in an RRSP or TFSA, do you stop to think, “How much did I have to earn to get my $5,000?” and then contribute the larger grossed-up amount to your RRSP?

Most people don’t.

Here is the formula to do the calculation, if you’re interested: investment amount/(1-MRT) = pre-tax earnings.

Also note that a small RRSP loan is a good strategy to gross up your RRSP investment. Pay off the loan when the RRSP tax refund comes.

If you don’t use the loan strategy, some investors will invest the RRSP tax refund, but the tax refund on $5,000 is smaller than the gross-up amount, so it is not as effective as grossing up your initial investment.

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The second table shows the after-tax results of investing the same amount in an RRSP or a TFSA, and investing the refund versus not investing the refund.

As you probably guessed, you are best off investing in a TFSA in almost every case. The slight exception can be seen in row three, when the RRSP tax refund was invested and the MTR at the time of withdrawal was lower than it was at time of contribution.

At this point, you may be wondering why you should ever consider investing in an RRSP. One reason is you can contribute more to an RRSP than a TFSA, but here are some other key things to consider based on income only.

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Incomes less than $45,000 and an approximate MTR of 20 per cent

The TFSA is likely the best option because your withdrawal MTR likely won’t be lower than your MTR at time of contribution; your tax-free withdrawals in retirement won’t negatively impact government benefits such as the Guaranteed Income Supplement (GIS), or tax credits such as the age credit; if you start investing young enough, the maximum TFSA contribution limit is probably all you need to save to support your current lifestyle in retirement when combined with Canada Pension Plan (CPP) and OAS.

An exception may be if you are trying to reduce your taxable income to claim more of the Canada Child Benefit (CCB).

Incomes between $45,000 and $90,000 with an approximate MTR of about 30 per cent

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This is the maybe/maybe-not range for RRSP contributions. Are you going to gross up your RRSP contribution? How much do you need to save for retirement? Is it more than what TFSA contribution limits permit? Will your MTR be lower when you retire?

Generally, most people in this income range will be contributing to RRSP accounts. The higher your income in this range, the more that RRSP contributions make sense.

If you are just above the $45,000 income or MTR level, consider contributing only enough to an RRSP to drop you into the lower tax bracket.

Incomes over $90,000 and an MTR over 40 per cent

At this income level your focus may be on maximizing your RRSP contributions and using up all past RRSP contribution room before making TFSA contributions. A goal may be to catch up on your RRSPs and then use the tax refunds to maximize your TFSA.

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There are many other factors to think about, such as income splitting, the RRSP Home Buyers’ Plan and Lifelong Learning Program (LLP), and the impact on government benefits and credits.

My suggestion is that you discuss your situation with a planner if you are not sure if you should be contributing to an RRSP or a TFSA. Or decide what you think is best for your situation and make a contribution to one of those plans. You won’t be making a bad decision and it is better to contribute to either one rather than do nothing at all.

Allan Norman, M.Sc., CFP, CIM, RWM, is both a fee-only certified financial planner with Atlantis Financial Inc. and a fully licensed investment adviser with Aligned Capital Partners Inc. He can be reached at www.atlantisfinancial.ca or alnorman@atlantisfinancial.ca. This commentary is provided as a general source of information and is intended for Canadian residents only.

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