How to decide between an RRSP or TFSA

Most people assume that the name Registered Retirement Savings Plan (RRSP) is a clear give-away for the preferential vehicle to use for retirement savings. It turns out that the distinction is not as clear-cut as the name would lead you to believe. This summary aims to touch on the important points that should guide you in deciding whether to place your savings into an RRSP or TFSA. Read on for details…

When the choice is clear…

One case where there is a clear-cut benefit to using a TFSA is as a short-term (approximately 5 years or less) savings vehicle, such as for a down payment, vacation, or other objective. For this application, the TFSA is much more convenient than an RRSP because withdrawals from the TFSA restore contribution room for the following year. This is contrary to an RRSP, where money once withdrawn cannot be re-contributed in a subsequent year.

The other case to use a TFSA is when one is over 71 and it is no longer possible to contribute to an RRSP. At this age, RRSPs must be converted to a Registered Retirement Income Fund (RRIF) or annuity, which both have mandatory withdrawals. Saving in a TFSA is the only option at this age.

When it’s no longer clear…

The more interesting case occurs when the objective is to find a long-term savings vehicle for retirement. Most people automatically assume the RRSP is better due to its name, but for long-term retirement savings, to determine the relative benefit of an RRSP versus a TFSA one needs to look at the tax bracket you are in now, as compared to the tax bracket expected in retirement.

Most people earn less during retirement, so they are in a lower tax bracket than when they were working full time. As a result, while still working, the RRSP would be the better choice to save for the future; it is more beneficial to obtain a 39% tax refund now, re-invest it, and then pay a 25% marginal tax rate on future withdrawals during retirement. However, if you make consistent contributions to your savings accounts, and expect to be in the same tax bracket during retirement, the tax differences between the RRSP and TFSA could be muted.

There are two exceptions to the above rule and they have to do with government supplements when one is in a specific tax bracket. For this analysis, it should be stated that both RRSP withdrawals and the Canada Pension Plan (CPP) are considered taxable income. You would thus need to include this in your retirement taxable income to determine your marginal tax rate in retirement.

Firstly, Old Age Security (OAS) starts being clawed back if your income (RRSP withdrawals plus CPP plus other sources) is above the middle tax bracket. If your retirement income is likely to be between $71,592 and $116,002 (for tax year 2014), you would need to pay back 15% of the incremental amount in OAS. Clearly, paying an additional 15% in lost benefits is not good if it can be avoided. In contrast, withdrawals from a TFSA are not taxable income, so they would not trigger this clawback.

Secondly, if you expect to be in the lowest tax bracket in retirement ($16,944 for single or $22,368 for a couple in 2014), you may qualify for the Guaranteed Income Supplement (GIS). Because RRSP withdrawals count as income, for every $1 in additional income the GIS decreases by $0.50 for an effective marginal tax rate of 75%. A TFSA is the obvious choice for this lowest tax bracket.

Using both a TFSA and an RRSP

Both the RRSP and the TFSA have contribution room limits. This means that many people who have sufficient financial assets will be able to fully max out one or both of the plans. In this case, it usually makes sense to contribute to the other plan until it, too, is maxed out. In the case of the TFSA, maximum cumulative contribution limit for 2014 is $31,000, which is insufficient for a comfortable retirement.

Canadian equity and fixed income has the same tax treatment in both an RRSP and a TFSA. However, as mentioned in our TFSA article, there is a tax treaty between the United States and Canada which enables you to reclaim a portion of the taxes on US dividends to be returned. As of 2014, this treaty only covers RRSPs, so foreign equity (especially US equity, but also foreign equity ETFs trading on a US exchange) should preferentially be kept in an RRSP.

Please contact CJ Capital if you have further questions on either TFSA or RRSP accounts.