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If you spend that RRSP refund then TFSA makes more sense

Over the last week or so, a few articles discussing the merits of contributing to the Tax Free Savings Account (TFSA) over the Registered Retirement Savings Plan (RRSP) and other RRSP contribution posts, really caught my eye.

The first one was on Passive Income Earner, where he discussed how to maximize your RRSP.

RRSPs are an excellent savings tool no doubt.  I have one myself and I contribute to it every month.  I’ve been contributing to my RRSP for over 10 years since my mid-20s.

RRSPs are excellent because the contribution you make 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 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:

  1. The tax deduction, and
  2. The tax-deferred growth.

Tax deduction

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.  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 refund to your TFSA or another registered savings vehicle (reinvested money for growth).

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.  

Tax deferred-growth

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”, you can open TFSAs that hold stocks, bonds and ETFs.  I know, because that’s my account.  You might know many of the TFSA benefits already.

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.  You can read another post about that:   I’ll maximize my TFSA first.

Based on my 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.

Amidst RRSP campaigns this winter, 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.

Filed in: Goals & Planning, RRSP, TFSA

31 Responses to "If you spend that RRSP refund then TFSA makes more sense"

  1. Dave says:

    On that TFSA soap box again ah Mark. Just kidding. I do understand the benifits, but as you said, they are not for everyone. I would argue that the only people who can really benefit are those who make good money and those with a lot of disposable income. I think the rrsp model tends to force people to save a little easier because contributing tends to be more structured. Also, it’s harder to get the money out prematurely. The money isn’t as available, which is probably a good thing in many cases.

    • @Dave,

      Yeah, I am :)

      Thanks for your comment.

      I see the TFSA as a gift for everyone really. RRSPs only make sense for some people and not even, if you’re not careful with that tax refund with the RRSP.

      For low-income earners, they should be using it because RRSPs don’t make sense for them. They are already paying little tax now, they will only have to pay tax on the RRSP withdrawal later in life. They are adding to their tax burden.

      For middle-income earners, the TFSA helps since although there is no tax contribution refund up-front, the nature of the account shelters tax permanently. This case can be made for all wage earners.

      For high-income earners, for sure the RRSP helps thems now but the taxes will come back to haunt them, unless they are paying much more tax now than in retirement. For very high-income earners, the benefits of the RRSP probably might trump the TFSA because of the present value tax refund.

      Regardless of what you make in wage and what you contribute, $50 per year, $500 per year, $5,000 per year, tax-free compound growth and tax-free withdrawals are an outstanding exemption.

      The RRSP model definitely is more forced savings, but I’d argue there are more incentives to contribute to the RRSP – tax refund – which is really a temporary government loan.

  2. Dave The TFSA is a much better option in many ways, for one thing any withdrawals are not taxed. In addition those withdrawals won’t be added to your income, or affect your government benefits, etc. The TFSA is a really good deal!

    Actually I believe it is the other way around – if you have higher income you benfit more from the RRSP since you are in a higher tax bracket and get a larger refund. The TFSA is a perfect solution for people who are not high income earners. I think once you actually look into the TFSA, you will find it is a great way to save for retirement.

    It’s up to people to make the effort to save whether its a TFSA or RRSP. If there are other reasons you are not saving, then its important to address those first. Unfortunately the TFSA has been poorly marketed which prevents people understanding the full benefits.

    Cheers
    The Dividend Ninja

  3. FG says:

    Mark, are you ever afraid that the government will rescind the TFSA and start taxing them? I’ve already seen complaints that they benefit the rich over the poor, even though the contribution limit is $5,000. Past a certain point though, compound effects dominate and the contribution limit becomes irrelevant.

  4. FG says:

    @THe Dividend Ninja

    What if you have a high income on retirement? The RRSP allows compound-free growth but I wonder about the overall effect.

  5. FG says:

    @FG

    Eh, I meant to say tax-free compound growth.

  6. FG says:

    What happened to LiveFyre? There’s no threads anymore :)

    • Hey FG!

      Yeah – I took a break from LiveFyre because I got some nasty spam comments on my site with it. I hope not too many people saw them. I tried to delete them ASAP!

      Seems Akismet is working much better. I will be emailing Livefyre to find out how to correct that, if I choose to activate the plugin again.

      Can’t you email me often and we can follow each other on Twitter for real-time updates? :)

  7. @THe Dividend Ninja Thanks for that rebuttal Dividend Ninja. I can’t argue with what you are saying. You probably know a lot more about this than I do. My thought on this has been that RRSP payments are generally structured with automatic withdrawal, etc. and it’s kind of hard to get at your money, and you’ll be taxed if you do take it out. If you’re very disciplined with your money, then I can definitely see the benefits of the TFSA. No doubt.

    My thought, and maybe I’m not giving people enough credit, is that if payments aren’t as automatic and you have easy access to the money, then you can dip into your “retirement savings” tax free before retirement. Maybe some people with pensions and who can already max out there RRSPs think that’s a great idea, which it would be in those scenarios. If TFSA is not intended for retirement and you can afford to contribute to an RRSP and TFSA, then fantastic. I just don’t know how many people can afford to do that. If the goal is a retirement fund, and you don’t want the temptation of a lot of tax free money at your fingertips, then RRSP might be a better idea. If you’re disciplined, then TFSAs are a good thing. I think it depends on the person. Both have merits.

    I personally think the TFSAs provides an advantage to those who have a large disposable income. It does so by giving them a way of investing tax free over and above contributing to or maxing their RRSPs. Something people with a moderate disposable income couldn’t realistically do or take advantage of.

  8. Elemag says:

    Mark, I enjoyed reading your post as usual. I agree that the TFSA might turn out to be the better investment tool. A man doesn’t have to be a prophet to predict that taxes will go up and up in the future. Let’s just think of all the federal and provincial deficits, the stagnant global economy, the aging population, the rising health care costs and last but not least the ever increasing appetite for social programs. Who is going to pay for all this- we will one way or the other. It doesn’t sound realistic- let’s turn eyes to Europe. So, it may turn out out that in 30+ years even if my (or anyone’s) income decreases in retirement, the tax amount paid might be the same or even higher. The conclusion- why not pay the tax now, contribute to your TFSA and forget about any future taxation on this money and reduction on government benefits and tax credits.

    • @Elemag,

      You are always very kind with your comments.

      I definitely think individual taxes will go up over time, and corporate taxes will go down. That’s just me. If my prediction is correct however, the TFSA will win for many. Not to mention, for all the sound, practical reasons you listed as well.

      If you can avoid paying any taxes now, it is best to do so. Thanks for reading.

  9. Mark, that’s an excellent post! I haven’t done the math between RRSP vs TFSA, I’m going to check out Retirement Advisor’s tool right now.

  10. @Elemag

    Ya I agree, the idea that tax levels are going to go up never really played into my thoughts on RRSPs vs TFSAs before. With my teacher’s pension on automatic, I think TFSAs are definitely the route for me as well.

  11. Avi says:

    That was the best and simple explanation, why TFSA is better that RRSPs. I do not put money into RRSP any more. All goes into TFSA and Non registered investments.
    Thanks

  12. @TheDailyThinker Thanx for the comment, and I wouldn’t say I’m trying to create a rebuttal here. The reality is we are all in different situatiions, different incomes etc. There really isn’t a one size shoe fits all scenario.

    However as MOA, points out you really need to look at the RRSP as a government loan – sure you get the refund, but you pay it back later. Yes its harder to take out your money from an RRSP than a TFSA. I do get that.. but don’t let that be the decision maker – you need discipline to use any investment strategy ;)

    Again, if you have a higher disposable income the RRSP is a better choice – not the other way around. That’s becuase you get a larger refund with a higher income. The TFSA is especially suited for those who aren’t higher income earners. As mentioned your RRSP deduction is lower with a lower income :)

    The TFSA means you don’t pay tax on the withdrawals. What’s not to get about that point? DO you really want to pay more taxes in retirement?

    But hey, as long as you are saving and investing, then that is the important point :)

    Cheers

  13. I like that you threw in the table in there! That’s awesome.

    I agree that the RRSP is just a glorified loan to yourself.

    I don’t even think it’s that great to use for the Home Buyers Plan either. I’m just paying back the minimum and then will focus on my TFSA.

    • Well thanks Y&T, I added the table for you!

      Kidding aside, the TFSA is a government gift to everyone. I just hope I can maximize it every year for the next 25 years and I’ll be in great shape for retirement :)

  14. Great article Mark,

    Right now most of the my cash goes to the mortgage followed by my RRSPs. At some point, i’ll focus on filling the TFSA account :)

    • @BTI,

      Thanks man. I think you’re wise to tackle that mortgage and RRSP. That approach should have your house paid off rather quickly. You can always play catch-up with your TFSA, that’s the beauty of that account. As you know, it’s there to max. out whenever you want.

  15. Great article Mark!

    In the end, there isn’t much difference between the RRSP and the TFSA if you use it for retirement. But having the discipline of reinvesting your RRSP tax return is harder than simply sending money over to your TFSA and don’t think about it!

  16. @The Dividend Ninja
    Thanks again for the information. You have given me something to think about. As I’m sure you would agree, learning is a process and what we thought was right or a good idea at one point in our life, we may later learn was wrong or a bad idea. I think a healthy discussion and getting information from others “more in the know” is a great way of learning and developing. Thanks again.

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