I’ll continue to maximize my TFSA first because…
A few years ago, after taking a well-deserved golf vacation in sunny Myrtle Beach, South Carolina with some great friends – I maxed out my Tax Free Savings Account (TFSA) for that calendar year.
I did so because, after talking to my friends on this trip, I told them this was my preference and my big money goal for that year. They were supportive of that. They know all about the never-ending TFSA vs. RRSP debate; they are smart money guys.
My position on this subject was rather simple – I prefer to maximize my TFSA before focusing on my RRSP because of the present day and long-term tax (free) benefits of that contribution.
This post will expand on that…
First of all, I want to say I’m a huge believer in savings for long-term investment purposes. This site is dedicated to that stuff. In this light I think both accounts work: TFSAs and RRSPs are excellent vehicles for long-term wealth creation. TFSAs can be self-directed investing accounts don’t you know – they don’t have to be a savings account. Heck, screw the debate and max out both accounts if you can! That’s a tall order though…which brings me to this.
I believe all investment choices should consider the tax attributes and your behaviours involved. So let’s revisit the basic tax characteristics of each account before we get to the behaviours:
- You do not receive any tax-deduction from a TFSA contribution; TFSA contributions are made with after-tax dollars.
- Any income or gains earned inside your TFSA (from interest, dividends or capital gains) are tax-free as the name of the account suggests.
- Any withdrawals from your TFSA are not taxable to you. If you make a withdrawal from your TFSA that amount will be added to the following year’s contribution room.
- As soon as you’re 18 years of age or older, you can have a TFSA. There is no age maximum for this account – you can own one (or many TFSA accounts) as long as you live.
- TFSA withdrawals are not counted as income.
Phenomenal stuff right? Yeah, I think so.
- Contributions to your RRSP are not counted as income; RRSP contributions receive a tax deduction to reduce taxes payable.
- Any income or gains earned inside your RRSP can grow tax-free until withdrawn.
- Withdrawals from an RRSP are taxable to you. They will be taxed as income regardless of source (from interest, dividends or capital gains) at your marginal tax rate.
- You must convert your RRSP to a RRIF (then start withdrawing), buy an annuity or cash out this account in the year you turn 71. So there is an age maximum on this account.
Still pretty impressive stuff.
But here’s the kicker…
If you decide to focus on your RRSP, which is great, then you need to manage the RRSP-generated tax refund well – it’s the linchpin in this debate.
The math says with all things being equal — particularly the tax bracket you’re in when contributing to either account and the tax bracket you’re in when withdrawing from either account — the RRSP and TFSA are a dead heat. The problem then becomes your behaviour. If you spend the RRSP-generated refund you’re investing less than you think and you’ll be taxed on all withdrawals.
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).
*Example for illustrative purposes; your marginal tax is amount of tax paid on an additional dollar of income. As income rises, so does the tax rate. This is different than a flat tax rate where you would expect to pay the same tax regardless of what your income is.
When your $1,440 cheque arrives, you decide to spend it on a trip to Cuba to escape our long, cold-winter. (I’ve been to Cuba it’s very nice.) 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.
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 I suggest you make some decisions about what you’re going to do with the RRSP-generated refund first – ensuring you always 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.
With a maxed out TFSA account every year I’ve already taken one of these decisions out of the equation. I’ve pretty much determined I either 1) reinvest the money back into the RRSP or 2) pay down debt.
Why the TFSA wins!
If you typically spend the bulk of your RRSP-generated “gift” consider prioritizing your TFSA over your RRSP because of the present day and long-term tax (free) benefits of that contribution. This is not the entire debate but a really important part of it.
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What’s your stance of the TFSA vs. RRSP? Invest in one? Invest in both? Why or why not?