Every year there are articles discussing the merits of contributing to the Tax Free Savings Account (TFSA) over the Registered Retirement Savings Plan (RRSP) or vice-versa. Most of the articles tout an RRSP is an excellent savings tool – no doubt. I have one myself and I contribute to it every month. I’ve been contributing to my RRSP since my mid-20s.
Contributions to the RRSP are excellent because the contribution you make today lowers your taxable income – and you may get a tax refund because of it – pretty nice formula. The problem some Canadians might have in using the RRSP is what they do with the tax-generated refund from the contribution. If you consider this tax refund a “gift”, that is, you are going to spend it all then you’re not really harnessing the power of the RRSP. Let’s dive deeper and revisit two key advantages of RRSPs:
- The tax deduction, and
- The tax-deferred growth.
Consider working in the 40% tax bracket:
- If you put $300 per month into the RRSP for the year, that’s a nice $3,600 contribution.
- You’ll get a $1,440 refund (40% of $3,600).
When your $1,440 cheque arrives, you decide to spend it on a trip to Cuba to escape our long, cold-winter. Sounds like fun…I’d love to do that too! When you do that however just know this $1,440 refund is effectively borrowed money – a long-term loan from the government they are going to come back for, in whole or in part (more on that in a bit). If you always spend your refund you are undermining the effectiveness of RRSPs because you are giving up your loan for tax-deferred growth. A refund associated with your RRSP contribution should not be considered a financial windfall but present value of a future tax payment you must make.
To really harness the power of your diligent RRSP contributions make some decisions about what you’re going to do with the RRSP refund first – ensuring you put the money to work. Consider the following as a few options:
- Reinvest it back into your RRSP (great bang for your buck).
- Pay down your mortgage (a guaranteed rate of return on debt + interest).
- Contribute the RRSP-generated refund to fund your TFSA contribution.
If you typically spend the $1,440 “gift” in my example then I think you’re better off prioritizing your TFSA over your RRSP because of the known benefits of that present day contribution.
At some point, the money that comes out of your RRSP will be taxed. The tax man will find you and he will ask for his refund. In my example, that’s your $1,440 if your marginal tax rate in retirement is the same as your working years today. It could be lower but with your Canada Pension Plan (CPP), Old Age Security (OAS), pension income and other investments, it could be higher.
With TFSAs, the government has eliminated the guesswork about how much the payback will be for the loaned money – because you don’t get any. You don’t get any tax break on the TFSA contribution so the government is nice enough to offer tax free withdrawals coming out. Even though TFSAs have largely been marketed as a “savings account” I have always suggested you open a TFSA to hold equities in the form of stocks or ETFs for many years – for long-term tax-free growth.
Personally, I have no idea of what my tax rate will be 20 years from now. I can guess but that’s about it. I have a pension and other investments. I’ll calculate all this out in a few decades when I’m a few years away from retirement age and ready to start accepting some income from government programs…if they still exist! If you know for sure your tax rate will be significantly lower in retirement than today, RRSP contributions are a wise thing to do. If not, making the TFSA a higher priority might be a better choice. Contributing to the TFSA today removes any guesswork about future marginal tax rates or any other federally income-tested programs down the road.
|TFSAs – Withdrawals are not considered taxable income. Income-tested benefits and income tax credits such as the GST Credit, Old Age Security (OAS) and the Guaranteed Income Supplement (GIS) aren’t affected by any TFSA withdrawals. Withdrawals don’t reduce these benefits.||RRSPs – Withdrawals are considered taxable income. RRSP withdrawals could reduce amounts you receive from income-tested benefits and income tax credits such as the GST Credit, OAS and GIS. RRSP withdrawals could reduce your post-retirement government benefits.|
I’m not suggesting to use one account exclusively over the other. Both accounts have great merits so you use both if you can! I contribute to both my RRSP and TFSA every year but the TFSA takes priority. Based on our current situation I’ll try and maximize my TFSA contributions long before I try to do the same for my RRSP. If you don’t invest the same that’s OK because your financial situation might be different. If you haven’t done some math on the TFSA vs. RRSP debate, I encourage you to check out this tool courtesy of Retirement Advisor and run some of the TFSA vs. RRSP math for yourself. You might be surprised by the results.
As always take some time to look at your financial situation and try and figure out what works best for you. Remember, nobody cares more about your financial future than you.