TFSA vs RRSP?
Picking The Right One Could Save You $100,000+ In Tax
Fee-for-service financial planner and founder of PlanEasy.ca
Both TFSA and RRSP are great, but they’re also different. These tax-advantaged accounts each have their own pro’s and con’s.
If you only have a set amount to invest each month, it’s important to pick the “right” account.
The “right” account can change over time as your income and personal circumstances change.
Each account, TFSA vs RRSP, deals with taxes differently. Choosing the right account will help you save $100,000+ in tax over your lifetime. Who would say no to $100,000?!?
By choosing the right tax-advantaged account, you can actually save less each month and still achieve all your financial goals.
Deciding Between TFSA and RRSP:
TFSA and RRSP are both tax-advantaged accounts. They both help you delay and/or avoid tax but they work a bit differently.
There are many pro’s and con’s for each account. Many of these pro’s and con’s aren’t strictly financial considerations and will depend on your personal circumstances.
For example, RRSPs are protected from creditors and cannot be seized to pay a lawsuit or bankruptcy. This isn’t the case for a TFSA which can be seized by your creditors. Read more about the pro’s and con’s of the TFSA and the pro’s and con’s of the RRSP.
Typically though, the main factor when deciding between a TFSA and an RRSP is usually taxes. If your tax rate today is the same as in the future, then it doesn’t matter, both TFSA and RRSP will work the same.
However, deciding between a TFSA and RRSP becomes challenging when your tax rate today is different than your tax rate when you start making withdrawals (ie. retirement).
This is where a little tax planning can really pay off.
Income Tax Efficiency:
If you anticipate your income will be higher in retirement (probably the case for most young people starting out in the work force) then the TFSA has the advantage.
If you anticipate your income will decline in retirement (the case for most people who are established in their careers) then the RRSP has the advantage.
As you can see, the difference can be large. A 14% difference is a huge amount when we talk about retirement savings. If you’re saving $1,000,000 for retirement then we’re talking about a potential $140,000 difference!
We can take the example above and create a TFSA vs RRSP matrix for all the income combinations. This gives us a map of where the TFSA is best vs where the RRSP is best.
It’s hard to predict the future. If you’re on the edge of a TFSA vs RRSP border, then you may want to start with the TFSA. Starting with the TFSA gives you the flexibility to change strategies in the future.
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BUT! Income tax efficiency is only half the story. The decision between RRSPs and TFSAs also needs to include income- tested government benefits. RRSP contributions boost your government benefits, TFSAs can’t do that.
Government Benefit Efficiency:
Claw backs on income-tested government benefits can add up quickly. This is especially true for low and moderate income families. Claw back rates can easily reach 20-40% for certain households.
The cool thing is that making RRSP contributions lowers your net income and boosts your government benefits.
In the eyes of the government, making a $1,000 contribution to your RRSP is the same as earning $1,000 less income. Your government benefits will increase in either scenario.
This can make RRSPs more attractive for low and moderate income families even when income tax rates are lower.
“Choosing the right account will help you save $100,000+ in tax over your lifetime.”
Combining Income Tax and Government Benefits:
To decide between TFSA and RRSP you need to look at your combined income tax rate and government benefit claw back rate. This is known as your marginal effective tax rate (METR).
As an example, let me share the TFSA vs RRSP analysis for my situation: two adults and two kids. My wife is at home with the kids so let’s say our family income has dropped to $50,000/yr but we’re targeting $60,000/yr in retirement.
In this situation, RRSPs surprisingly provide a much larger benefit, 97% greater to be exact.
This is counter intuitive because our income is lower now than in retirement. This usually means TFSAs are a better choice, but due to the high level of government claw backs, an RRSP contribution will boost our government benefits and provide an income tax benefit. This combined effect makes an RRSP contribution a clear winner.
But what about other income scenarios? By recreating the same matrix we did above we can look at all income scenarios for my situation (to make it easier to read we’ve zoomed in on just a few combinations, here is the full matrix).
As you can see, nearly every scenario favors the RRSP. This is mostly due to the very high claw back rates on child benefits like the Canada Child Benefit and the Ontario Child Benefit. The combined Marginal Effective Tax Rate (METR) is lower in retirement for nearly every scenario.
TFSA or RRSP?
Deciding between a TFSA contribution or an RRSP contribution can be confusing. Making the wrong decision could cost you $1,000’s in taxes. Plus, it means you’ll need to work harder and save more to achieve the same financial goal.
Whether you’re receiving government benefits now, or anticipate receiving them in the future, making the right decision between TFSA or RRSP can help you reach your goals faster and with less effort.
This is where a good financial planner can help maximize your savings.
Financial planner, personal finance geek and founder of PlanEasy.