RRSP or TFSA

I am often asked the question, “What is better for my savings, a Registered Retirement Savings Plan (RRSP) or a Tax Free Savings Account (TFSA)?”  My answer always is, “It depends.”  To make your best choice you need to consider the following:

1. What will the money saved be used for? Saving for a car, vacation or emergency fund would favour TFSA. Saving for your retirement would favour a RRSP.

2.  What is the investment time horizon? If you need the money in five years or less, the TFSA may be a better choice. RRSP money is better suited for long time horizons.

3. What is your tax rate now when you acquire the TFSA or RRSP and what will the tax rate be when you draw the money out? If your tax rate now is lower than you expect it to be in the future,  the TFSA will save your total income tax outlays. If your tax rate now is higher than you expect it to be in the future the RRSP will reduce your total income tax outlays. 

A TFSA is a mirror image of a RRSP. For example, if we assume you have $1,000 to invest over ten years and you are in the 30% tax rate and the tax rate will be constant, your investments will earn you 5% (ignoring compounding for simplicity), and the time horizon is ten years. Here are the results:

The TFSA investment will be $700 ($1,000 less the $300 tax). Each of the ten years earns $35 of income ($700 x 5%) for a total of $350 ($35 x 10). The TFSA balance at the end of ten years is $1,050 ($700 + $350). The balance of $1,050 can be drawn out of the TFSA with no additional income taxes owed.

Using the same facts as above, for an RRSP investment of $1,000 the results are as follows:  Each of the ten years earn $50 of income ($1,000 x 5%) for a total of $500 ($50 x 10).  The RRSP balance at the end of ten years is $1,500 ($1,000 + $500).  The balance of $1,500 is taxed at 30% so $450 income taxes due ($1,500 x 30%) leaves $1,050 after tax dollars. 

You can see from the above calculations that the end result for both TFSA and RRSP accounts will be the same if the tax rate is the same across the investment time horizon. If you expect to be in a lower tax bracket in the future the RRSP is likely the better way to go and if you expect to be in a higher tax bracket the TFSA is the way to go.

TFSA contribution room is currently set at $5,500 per year. Any unused amounts earned in a prior year are carried forward and can be used in subsequent years. Amounts withdrawn from your TFSA creates additional contribution room for subsequent years. Overcontributing to your TFSA results in a 1% per month penalty for the overcontribution.  CRA has assessed income taxes on TFSA where there are significant gains from trading securities within the TFSA. CRA’s position is that trading gains are business income from the business of trading, so income tax is applicable.

The RRSP contribution limit is 18% of prior year income to a maximum of $26,230 for 2018. Any unused amounts earned in a prior year are carried forward and can be used in subsequent years. Amounts withdrawn from your RRSP does not create additional contribution room. Overcontributing to your RRSP results in a 1% per month penalty for the overcontribution in excess of $2,000.

You should consult with your investment advisor as well as your tax advisor to determine what amounts you should allocate to your RRSP and TFSA accounts each year.

For more information please consult with your professional tax advisor.