Last updated on February 2nd, 2021 at 12:36 am
Around this time of the year, Canadians are comparing their TFSA vs their RRSP and asking, “which account should I contribute to?” Well, the answer is a little complicated and may depend on your income level. In this guide, we’ll go through a few different scenarios to help you understand which account is the ideal investment vehicle for your retirement.
- Comparing TFSA and RRSP Contributions
- The Impact of Marginal Tax Rates
- TFSA vs RRSP: Income Level Comparison
- When a Taxable Account is Superior
- TFSA vs RRSP: An Example
- Thanks for Reading!
Comparing TFSA and RRSP Contributions
Both your TFSA and your RRSP are powerful, wealth-building accounts. Each will allow your investments to grow tax-free; income earned from your investments will not be taxed, and selling holdings in your account will not trigger a taxable event. However, there are some key difference between these accounts:
- TFSA contributions are made with post-tax income and are not taxed on withdrawal.
- RRSP contributions are made with pre-tax income and are taxed as income on withdrawal.
Contributions to an RRSP being “pre-tax” means that those contributions reduce your taxable income for the year. Having a reduced income will reduce your income taxes and may generate a tax refund. The size of the refund you receive will be equal to your marginal tax rate multiplied by your contribution. So, if your marginal tax rate is 20%, a $12,500 deposit into your RRSP would generate up to a $2,500 refund at the end of the year.
Optimizing Your RRSP Tax Refund
It’s important to understand that your refund may be less than your marginal tax rate would imply. That can happen if your contribution reduces your income enough to reduce your marginal tax rate. For example, let’s say contributing $10,000 kept you within the 20% tax bracket, and the next dollar dropped you into a 15% tax bracket. The next $2,500 you contribute will yield a refund of $375. That’s much less than the $500 you would have received if you were still fully within the 20% income tax bracket. For that reason, it’s best to use an income tax calculator to determine how much to contribute to your RRSP to receive the maximum tax benefit.
If you plan on making RRSP contributions throughout the year, you can choose to fill out form T1213 Request to Reduce Tax Deductions at Source. This form instructs your employer to not withhold taxes on a specific amount of income that you plan to contribute to your RRSP. As a result, instead of receiving a refund when completing your tax return, you will avoid paying that amount of income taxes over the course of the year.
The Impact of Marginal Tax Rates
The fact that RRSP contributions are made with pre-tax income – and that contributions are taxed as income on withdrawal – has a huge impact on whether the TFSA or the RRSP is the right investment vehicle for your retirement. Consider an investor with a 20% marginal tax rate who expects to have a 20% marginal tax rate in retirement. Let’s also assume that they’ve submitted a T1213 form to their employer to avoid having to wait for a tax refund from their RRSP contributions. The net benefit of the two accounts after 25 years – assuming an 8% return – looks like this:
We can see that the TFSA and RRSP perform the same if your marginal tax rate in retirement is the same as your marginal tax rate when contributing. However, this situation doesn’t apply to everyone. Many Canadians can expect to have a different income tax rate in retirement than they have in their working years.
When to Contribute to an RRSP
Consider an investor who expects a 20% marginal tax rate in retirement and has a 30% marginal tax rate during their working years:
This investor is 14% better off in retirement by contributing to their RRSP instead of their TFSA. Even with just $10,000 invested, the extra benefit of using their RRSP was $9,783 after 25 years. This makes it clear that estimating your marginal tax rate in retirement and contributing appropriately based on rate today can yield huge benefits in retirement.
When to Contribute to a TFSA
There are plenty of reasons why contributing to a TFSA is a better choice than contributing to an RRSP. The main reason is that money invested in a TFSA is still totally accessible without penalty. But, for the sake of our discussion, let’s consider when a TFSA is a superior choice from the perspective of marginal tax rates. Consider an investor with an expected 40% marginal tax rate in retirement and a 20% marginal tax rate while contributing:
Because their tax rate is higher in retirement than when they contributed, this investor is 12.5% worse off by choosing to invest in their RRSP instead of their TFSA. This amounts to an effective loss of $8,561 compared to simply investing in their TFSA.
TFSA vs RRSP: Income Level Comparison
With our investigation into marginal tax rates in mind, let’s dig into which account is generally better for Canadians at different income levels.
Low-Income Earners: Prioritize TFSA Over RRSP
The simple answer for low-income Canadians is that it’s always better to contribute to a TFSA instead of an RRSP. That’s because their marginal tax rate in retirement is often the same or higher than in their working years. CPP, OAS, and GIS all count as taxable income in retirement. These income sources often push low-income Canadians into a higher tax bracket than when they were working.
If your income is low enough that you’re not paying income tax, contributing to an RRSP will not yield any tax refund at all. Instead, contributing to a TFSA – where your money can grow tax-free and not be subject to income tax in retirement – is superior to contributing to an RRSP.
Middle-Income Earners: TFSA and RRSP
If your income is moderate, the best strategy is to contribute to your RRSP until your marginal tax rate is the same as your expected rate in retirement. Any additional contribution would be better invested in your TFSA. If you’d like to make additional contributions and your TFSA is full, contribute that money to your RRSP. The benefit may be reduced if your marginal tax rate falls below your rate in retirement. However, the benefit of tax-deferred and tax-sheltered growth is almost always superior to investing in a taxable account.
The answer is a little different if you expect that your working income will increase substantially in the future. In that case, the best strategy may be to contribute to your TFSA first. Later, once your marginal tax rate increases significantly, you could start contributing to your RRSP.
High-Income Earners: TFSA and RRSP
High-income Canadians are the best positioned to get the most benefit from their TFSA and RRSP accounts. The ideal strategy is to work on maxing your TFSA while also contributing enough to your RRSP each year to reduce your marginal tax rate to be close to your rate in retirement. Once your accounts are full, it’s best to continue maxing both accounts every year. That way you can take full advantage of tax-free and tax-deferred growth.
When a Taxable Account is Superior
Despite these general rules, it’s still important to estimate your marginal tax rate in retirement. That’s because there are indeed situations where investing in a taxable account is superior to investing in your RRSP. It can sometimes happen if you’re investing in tax-advantaged assets like equities, and your income in retirement is much higher than your income while contributing, or your retirement is relatively soon.
Consider an investor who contributes at a 30% marginal tax rate and has a 50% tax rate in retirement. Let’s assume they’re only investing in equities (which are taxed at half of their marginal rate). To keep things simple, let’s also assume that their portfolio generates no dividend income and requires no rebalancing.
In this example, using a taxable account was a slightly better choice than investing in an RRSP. However, for the vast majority of Canadians, this contrived scenario won’t apply.
TFSA vs RRSP: An Example
As someone with a relatively high income, I am working on maxing my TFSA while also contributing to my RRSP. I try to contribute enough to my RRSP to take me out of the highest tax bracket I’m in – approximately 40%. I then contribute the rest of my money into my TFSA. Eventually, once my TFSA is maxed, I’ll focus on maxing my RRSP to take advantage of tax-deferred growth and potentially receive larger Canada child benefit payments.
My wife earns a moderate income and expects to be in a higher-paying job in the future. So, her strategy has been to contribute to focus on contributing to her TFSA. Hopefully, by the time her TFSA is maxed, she’ll be in a higher-paying job and will be able to extract the maximum benefit from her RRSP.
Thanks for Reading!
Thank you so much for reading! I hope that my analysis and real-world examples help you decide whether to contribute to your TFSA or your RRSP. If you’d like to read more of my content, please check out my article on home office expenses. Or, if you’d like to read more about investing, read my review of the best Canadian dividend ETFs! Follow me on my journey towards financial independence by following AnotherLoonie on social media or signing up for my monthly newsletter!