When Money is Tight: TFSA or RRSP?

Evelyn Jacks

Is it better to invest your money into your TFSA or RRSP? It’s a choice many have to make between now and the March 2 deadline for RRSP contributions.  The date is important because missing it means you could miss out on increased Canada Child Benefits, or be subject to an expensive clawback of EI or OAS benefits.  We’ve done some calculations for you so here’s what you need to know:

The TFSA seems to be the wealth winner over time, even in cases where income splitting is available in retirement. But there is a wild card: you need to consider which tax bracket you’ll be in both at the time of RRSP contribution and at retirement and what effect the RRSP will have on your refundable and non-refundable tax credits.

Some basic rules to begin with:  it’s important to remember that the TFSA must be funded with after-tax dollars. The RRSP, however,  creates a tax refund on contribution and so is invested on a pre-tax basis.  That’s the important first lesson – if you are taxable, the RRSP will reduce your taxes by your marginal tax rate.  The more you make the better the benefit. 

In both plans, earnings are tax-sheltered while they reside in the plan. So that’s an excellent reason to top up savings in both. 

But there is a big difference upon withdrawal: all amounts (principal and earnings) are withdrawn tax-free from the TFSA; all amounts are fully taxed if they come from the RRSP.  However, a saving grace is that the RRSP withdrawal income can be split with a spouse in retirement. 

How does it pan out over a lifecycle?  Here’s an example with a single $5,000 deposit that could be made in either a TFSA or an RRSP. Assume the tax bracket is 25% when the taxpayer starts saving, earning 3% annually on the deposit over time. The taxpayer’s tax  brackets gradually increase until the money is withdrawn 40-years later. The results are compared for investments in an RRSP, a non-registered account and a TFSA.

Result #1 – Both tax-preferred investments beat the non-registered account in terms of wealth created.

Result #2 - The RRSP comes out ahead of the TFSA when the current MTR (Marginal Tax Rate)  is higher at the time of contribution than at retirement.   Income splitting with spouse will go a long way to mitigate the effects of high income at retirement.

Note that in the first chart, the RRSP contribution generates a $1,250 tax refund. This refund grows on a tax-sheltered basis to $16,310 vs the $12,232 for the TFSA (which has to be funded with after-tax dollars).

But, along with that RRSP deduction up front, comes an income tax liability at the end of the line of close to $6000. The investor matches the TFSA results when the RRSP benefits are split with a spouse.

Here’s how it looks in a chart: 

Non-Registered Account

RRSP

TFSA

©2020 Knowledge Bureau Inc.  All rights reserved.

Non-registered savings alone, come up short because of the tax bite along the way. The best case may be to use the TFSA when the current marginal tax rate is lower than expected in retirement and the RRSP when the current marginal tax rate is higher than the expected tax rate in retirement. However, there are other important considertions.

The RRSP deduction also increases access to refundable and non-refundable tax credits throughout your lifetime and this must be factored in. The biggest effect here is on the Canada Child Benefit. The size of the tax advantage depends on both the number of children and the family net income. The following table shows the additional savings generated by an RRSP contribution (because they would increase the taxpayer’s CCB.)

Additional savings (%) generated by lower reductions in the Canada Child Benefit

This reduction of lucrative refundable tax benefits effectively increases the marginal tax rate by up to 23% thereby increasing the overall tax benefits received by making an RRSP contribution. 

How much do you save when income is $85,000 and you make a $15,000 RRSP contribution?  In a family with 3 children, every dollar of income over $68,708 results in an $8.00 reduction in the Canda Child benefit.  When income is between $31,711 and $68,708, every additional dollar of income results in a reduction of $19.00 in CCB benefits.  Using an RRSP contribution to reduce net income from $85,000 to $60,000 results in an increase in the CCB of ($68,708 - $60,000) x 19% + ($85,000 - $68,708) x 8% = $2,957.88!

Another big winner is the recipient of Employment Benefits whose net income is over $66,375 ($67,750 in 2020), who potentially avoids a 30% clawback of EI benefits by making an RRSP contribution to reduce that net income below the clawback zone. 

High income seniors also have some advanced planning to do. RRSP withdrawals may trigger the OAS Recovery Tax (clawback) for taxpayers over age 65,  adding the equivalent of an additional 15% tax on the withdrawal amounts. If the OAS clawback cannot be avoided, the additional cost would make the TFSA contributions more attractive.

So what’s the right answer? Perhaps you should do both, and contribute to your RRSP to get the tax savings now together with the most from income-tested  refundable tax credits and social benefits available to your family. Then contribute what you save in taxes and benefits to your TFSA for each adult in the family who is a resident of Canada to construct a tax free retirement in the future.

There are lots of alternatives in planning retirement income, which is  the subject of a great certificate course from Knowledge Bureau: Tax Efficient Retirement Income Planning. It includes a sophisticated 20 year retirement calculator that can help you answer the question:  Will we have enough?

It’s your money - your life. Take the time to crunch the numbers for a better handle on your investment options before the end of the month and leverage your savings opportunities to get the best after-tax results over the long term.

Evelyn Jacks is president of Knowledge Bureau and the author of 55 books on tax and personal wealth management. Follow Evelyn on Twitter at @EvelynJacks.  Walter Harder is a Master Instructor with Knowledge Bureau.

Additional educational resources: Help your clients, or help yourself generate tax-efficient retirement income by taking the MFA™ – Retirement & Succession Services Specialist Program or the newly revised RWM™ Certification Program.

COPYRIGHT OWNED BY KNOWLEDGE BUREAU INC., 2020.

UNAUTHORIZED REPRODUCTION, IN WHOLE OR IN PART, IS PROHIBITED.