Is RRSP Winning the Challege by TFSA?
RRSP and TFSA are both government registered programs to encourage Canadians to put monies aside for their specific financial goals. While both programs carry the word “Saving” in their names, both TFSA and RRSP are investment baskets that reduce taxes on investment income. However, investing in one might work better than investing in the other, depending on the situation. Generally speaking, the TFSA is easier to manage, and is more flexible than the RRSP. On the downside, at least for most income earners, it is limited in its annual contribution room.
Notwithstanding the difference in the amount that one can contribute to each program, in theory, there is not much difference in the amount of money that one ends up with, regardless of whether one invests in TFSA or RRSP. From a tax perspective, the only difference is how and when the contributions, or the withdrawals are taxed. Considering the resulting tax refund, or otherwise reduced taxes payable, RRSP contributions are made out of pre-tax earnings. As such, any withdrawal from RRSP accounts are taxed. In contrast, contributions to a TFSA are made with after-tax income and therefore any withdrawal from TFSA is not subject to tax. With the above in mind, as the table below shows, regardless which one of the programs one invests in, one ends up with the same amount of money.
|Taxation of RRSP vs. TFSA||RRSP||TFSA|
|Assumed marginal rate of tax at contribution date||35%|
|Assumed average annual rate of return on investment||6%||6%|
|Investment period in years||20||20|
|Value after say 20 years||13,242.81||8,607.82|
|Assumed marginal rate of tax on Withdrawal date||35%|
|Net amout after tax||$8,607.83||$8,607.82|
It should be noted that the underlying assumptions in the above calculation are often deviated from in real life. For example, RRSP investment portfolios are balanced for long term (retirement) growth, whereas the TFSA investment porfolios are often balanced for the short term with lower expected rate of return. Additionally, if properly planned, it is reasonable to assume that one’s marginal rate of tax at retirement is less than the rate prevailing at the time when the contributions are being made. Despite these reservations in the underlying assumptions above, the point being made stands true and it is that from a tax perspective the programs are very similar.
Despite the similarities of the two programs, there are nevertheless situations where only one of the programs is available or most suited. In general, there are a few factors that come into play when selecting between the two programs. These factors, among others, include the saver’s age, the current level of income, and the situation concerning planned retirement income. For example, for a person who is 71 years of age or for a younger person who does not have any “Earned Income” (to qualify for RRSP contributions), the only available program is the TFSA. On the other hand, for a working person currently in a high tax bracket and planning for a modest retirement income, making RRSP contributions could be considered a better choice.
In light of the above, it is clear that without detailed personal and family financial information it is not possible to suggest which one of the two programs best suit a situation. However, the following two lists attempt to provide a guide as to the situations where one program MAY be preferable over the other.
1. CASES IN FAVOUR OF TFSAs
a. Young entry-level income earner: If you are just entering the workforce in Ontario and have an annual income of less than $40K in 2019, then contributing to a TFSA, for the time being, is the way to go. In the process, you will maximize your TFSA now, while carrying your RRSP contribution room forward to future years. You continue to contribute to your TFSA until you are in a higher marginal tax bracket at which time you’ll withdraw from your TFSA to hit the optimize your RRSP contributions.
b. An older taxpayer with little income:
If you are close to retirement, and expect to qualify for the Guaranteed Income Supplement (GIS), contributing to a TFSA is preferable. This is because eligible GIS benefits decrease by $1 for every $2 in additional income above the maximum threshold.
c. An older taxpayer with good income: If you expect your retirement income to exceed the threshold for clawback of OAS ($77,580 – $123,386 for 2019), then you should probably not contribute to your own RRSP.
d. No income or no “Earned Income”: Funds contributed to a TFSA can come from any source. This means you can use the TFSA to start investing tax-free even if, under the rules you cannot contribute to an RRSP account.
e. Short term savings goals: TFSA is an excellent investment tool for short to medium term goals such as a car purchase, emergency funds, travel, etc. You can withdraw the money quickly without tax implications.
f. Investing after 71: Seniors 71 years of age or older cannot under the rules contribute to their RRSP. In contrast, one can contribute to TFSA at any age.
2. CASES IN FAVOUR OF RRSP
a. Substantially higher contribution room: If you are in the middle to high tax bracket, qualify under RRSP rules, and intend to save more than the TFSA annual contribution room (2019 -$6,000) in your retirement funds, then RRSP is the vehicle of the choice. Otherwise, you may, for now, contribute to the TFSA that you have designated for retirement, instead. Should your income increases in future years you have the opportunity to transfer from your retirement TFSA to your RRSP account.
b. Group RRSPs: RRSPs are most attractive and preferable when your employer matches your RRSP contributions Investing in RRSP in this situation is preferred, regardless of your current tax bracket or any other consideration.
c. Rigidity to rescue: RRSP, as the name suggests, is meant and is designed for saving for retirement. As such, it isn’t as flexible and friendly when it comes to withdrawing funds from it. This lack of flexibility makes RRSP funds less accessable than the TFSAs from which you can withdraw easily and with no tax implications.
Both TFSA and RRSP are excellent investment vehicles that Canadians can take advantage of in achieving their financial goals. The rules governing RRSP accounts are such that they are best suited to retirement planning. Accordingly, while the maximum annual RRSP contribution room, relative to that of TFSA, is substantial ($26,300 vs $6000 in 2019), but qualifying for RRSP contribution is restricted to the contributor’s age, type, and amount of income. TFSA, on the other hand, is available to all resident Canadians age 18 and over. Furthermore, the maximum annual TFSA contribution is the same for all Canadians (2019 – $6,000) regardless of their income. Such flexibility makes TFSAs very attractive.
No doubt that there are specific situations where RRSP is the right program for some Canadians but the flexibility and liberal nature of TFSA makes it a far more attractive program. As such, if possible, TFSA, at least on a transitional basis, should be maximized on a monthly basis and when the situation warrants it augmented and transferred to the taxpayer’s RRSP account. As the last word on the effectiveness of TFSA, suffice to note that if a person invested at 7%, the current annual contribution room consistently on a monthly basis from age 18 for 37 years, when the person is only 53 years of age, the accumulated sum would well exceed a million dollars which at at 35% tax rate would be in excess of $1.6 million in RRSP funds.
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