TFSA or RRSP?

In 2009, the Government of Canada introduced a new financial tool to help Canadians save for the future. The Tax Free Savings Account (TFSA) allows any Canadian over the age of 18 to grow their savings without having to pay tax on accumulations or withdrawals. Money can be withdrawn from a TFSA at any point without penalty. This is in contrast to the Registered Retirement Savings Plan (RRSP) which provides a tax refund when you make a contribution however, all withdrawals will be taxable.

The major banks have made it confusing for people to understand what a TFSA can really do. By offering “High Interest” Tax Free Savings Accounts they give the impression that a TFSA is just a place to store your cash. In reality, an RRSP and TFSA can and should be used to invest in the exact same way by investing in products that will provide strong, long term growth for your savings.

There are many rules and details when it comes to contributing and withdrawing from either type of account but just to clarify, the simple differences are as follows:

TFSA RRSP

Each type of account has pros and cons but both are great options if you want pay less tax. So, in which account should you invest? Well, ideally, both! However, many Canadians don’t have the luxury of having that level of savings every year so we’d like to show a situation that may help to guide your investing for the future.

Sarah is 40 years old and is looking to retire in 20 years at age 60. She is earning $60,000/year and has a small amount of cash savings but most of her disposable income has been used to tackle credit card debt and pay down her mortgage. At this point in her life she wants to start focusing on her savings goals for the long term but she is unsure of what she should do with her new savings. She asks, “should I invest using a TFSA or an RRSP?”

Let’s first take a look at what would happen if she chose to invest in an RRSP account.

Fast forward to where Sarah is now entering retirement at 60 years old. She was diligent and consistent with her savings for the past 20 years and was able to contribute $5,500 per year to an RRSP which earned a return of 6%. Those contributions earned her a tax refund of $1,925 per year. She chose not to spend that money on clothes, a vacation or renovations but instead, she reinvested the refund which earned a conservative 4% per year after taxes in a non-registered account. At this point, her total account value has reached over $260,000! Her money has more than doubled by saving regularly and by letting her money work for her.

Sarah figures that if she will need money for another 20 years, she can withdraw approximately $24,000 every year until she is 80 years old from a combination of her RRSP and her reinvested tax refunds. However, she must consider the tax she will have to pay on that money withdrawn from the RRSP. After taxes paid, Sarah will be able to spend just under $16,000.00 of her savings every year. That will be a nice addition to her pension income, CPP and OAS payments in the future but the taxman took a large portion of her savings!

Alright, now let’s see what would have happened if she would have saved using a TFSA instead of an RRSP.

The same situation applies here: Sarah has been saving $5,500/year in a TFSA for the last 20 years, earning 6% per year on her investments. Sarah will not receive a tax refund for her contributions so her account will grow based solely on her $5,500 savings per year. Now that she has reached retirement age, her account has grown to just over $200,000 which, at first glance, is significantly less than the RRSP account total.

Here is where the TFSA really shines. Even though her pre-tax account value is much smaller, Sarah does not have to pay any tax on her withdrawals from the account! So, based on the same 20 year retirement, she will be able to spend approximately$18,000.00 every year which is $2,000.00 more than her RRSP every single year!

What would you do with an extra $2,000.00 to spend every year? Take a warm vacation, buy a new set of golf clubs or maybe treat your children or grandchildren to some extra Christmas or birthday gifts! Those are the fun decisions to make in life and you can let yourself make those decisions by choosing to start saving with a TFSA before saving with an RRSP.

The following pages will show three situations based on income and which marginal tax bracket you might fall into. We show what might happen if you invest $5,500/year in either a TFSA or RRSP for 10, 20 or 30 years and then compare the two to see which account will allow you to withdraw more per year over the course of a 20 year retirement.

If you earn $30,000 per year (26% Marginal Tax Rate):

30000 Per Year

* 6% annual return. RRSP returns are reinvested in a non-registered account earning 4% net

Annual Withdrawal in Retirement:

[table id=2 /]

If you earn $60,000 per year (35% Marginal Tax Rate):

60000 Per Year

6% annual return. RRSP returns are reinvested in a non-registered account earning 4% net

[table id=3 /]

If you earn $100,000 per year (38% Marginal Tax Rate):

100000 Per Year

6% annual return. RRSP returns are reinvested in a non-registered account earning 4% net

[table id=4 /]

Assumptions Which may Affect the Results*

  • For each income level, it is assumed that you remain at that income level throughout your 10, 20, or 30 year savings period as well as through your 20 year withdrawal period.
  • Tax rate remains the same throughout your savings period and withdrawal period.
  • Savings are based on $5,500 CAD per year which is the current (2016) TFSA maximum
  • TFSA contributions are left in the account for the entire savings period
  • Consistent 6% annual returns. Annual average of 6% will yield different results.
  • RRSP refunds are reinvested into a non-registered account earning a net 4% annually to account for any taxable dividends and/or capital gains taxes

Looking at these results, most clients would benefit from investing in a TFSA! There are many other real world scenarios that could affect these results especially considering the different tax situations that can arise in the future but even considering many of those other options, we feel comfortable recommending that most clients focus on maximizing their TFSA accounts first and then invest in an RRSP if they have more money left to save.

The bottom line when it comes to the two accounts is this:

1) If you can contribute to a TFSA, do it.
2) If you have maxed out your TFSA contributions, invest in an RRSP.
3) Once you’re invested in either type, don’t spend any of it until you absolutely need it.
4) Save more and let your money work for you

*The information provided is general in nature, and should not be relied upon as a substitute for advice in any specific situation. For specific situations, advice should be obtained from the appropriate legal, accounting, tax or other professional advisors.

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