RRSP Vs. TSFA
There is almost endless writing, discussion and debate in books, the internet, TV and in investment advisory offices across Canada, about which is better – RRSP Vs TSFA. But let’s cut through all the noise and focus on answering the main question:
Which will help your investments make you more money over time, the RRSP or the TSFA?
The answer to this is really quite simple: For the vast majority of Canadians, the TSFA will help you earn more on your investments over time. For some Canadians in one particular circumstance, it is the RRSP.
More specifically: Once you are finished maxing out your contributions to a TSFA (with a current yearly cumulative maximum of $5,500 as of 2016), then begin to contribute to an RRSP.
The only exception to this general rule is if you have the opportunity to invest with an employee sponsored pension or investment programme that matches your investment contributions. This should supersede any other strategy 99.9% of the time. There’s no money like free money.
If snippet is all you require move forward, great. There’s nothing wrong with making your investment decision simple and decisive. However if it hasn’t quite scratched your itch, and you’d like to know WHY the TSFA comes ahead in most cases, and WHAT the circumstance is when an RRSP will be better – then we invite you to read on.
Head to Head: RRSP Vs. TSFA Benefits
In order to properly compare RRSPs Vs TSFA it helps to know what they are, and the top benefits of each.
RRSPs and TSFAs are not investments in and of themselves, but government sponsored accounts that can hold a variety of investments, such as stocks, ETFs, mutual funds – even gold and some real estate. What does ‘government sponsored’ mean? It means that for both of these accounts, the government will provide tax benefits that help your money to grow.
Main RRSP Benefits:
- Money invested is tax free. An RRSP purchase lowers the income that you pay tax on (by the amount of the investment). So if you have already paid taxes on the invested amount, this can result as a tax refund in the year.
- IF the tax refund is also invested, this provides opportunity for improved investment amounts, and improved effects of investment compounding. Over time these effects can enhance the return of a portfolio substantially.
- Lower tax rates at withdrawal. When an RRSP is withdrawn, income tax must be paid on 100% of the amount at your marginal tax rate*. For some Canadians, their marginal tax rate is lower during retirement than periods of higher income during working years. Saving taxes based on a 50% marginal tax rate (during working yers) beats paying taxes at a 35% marginal tax rate (when retired) any day. Also, after age 65, RRSP withdraws (known as RIFFs) can be split with a spouse to further lower taxable income, and potentially marginal tax rates.
*The Marginal Tax Rate is the amount of income tax paid on your last dollar earned. In Canada there is a graduated tax system meaning that as your income increases, the income tax paid increases. For example, an individual earning $100,000 per year pays more tax on their last dollar earned than an individual earning $35,000.
Main TSFA Benefits:
- Money withdrawn from a TSFA is tax free (unlike an RRSP). Money invested into a TSFA is tax paid income (unlike an RRSP), and attracts no refund.
- Investment growth avoids income taxes. With the exception of selling an owner occupied house, there is little to no opportunity in Canada to completely avoid income taxes on investment growth, other than within the TSFA. This is a huge deal when the compounding of investment returns is considered.
- Does not increase retirement income. By not increasing income on withdrawal at retirement, this will help to ensure maximum Old Age Security and other government retirement benefits. Those with the lower incomes at retirement will gain the most benefit from government retirement support programmes, and the government is likely to continue lowering retirement benefits for higher income retirees.
It is often mentioned in some articles that a benefit of TSFAs is that they are flexible, and can be used for any savings purpose. However it would not be fair to compare the benefits of an RRSP which is primarily a retirement savings account, to an account that is not used for retirement. That’s an apples to oranges comparison, and we want to stick with apples to apples by focusing on a retirement savings comparison. The same things can be said for using RRSPs for the Canadian Home Buyers Plan, and Life Long Learning Plan. If you are saving to buy a house, or go back to school – this is a different discussion.
Why TSFAs are Usually Better (using an example)
To help clarify our point, let’s use an example: RRSP vs. TSFA taxation example at a 40% marginal tax rate both before and after retirement.
What this handy little comparison chart tells us is that, even though its nice to get an RRSP income tax refund (1) The refund needs to be invested to be effective (2) On withdrawal, given the same marginal tax rate (based on similar retirement income), the return on investment is the same.
The TSFA comes out ahead, because for Canadians earning more than $72,809 during retirement (and therefore well within a 40% marginal tax bracket), each dollar of income is reduced by 15% or $0.15 due to effects of the Old Age Security claw back. With an income of $117,000 the Old Age Security entitlement is completely clawed back, or dissolved. This represents potentially thousands of dollars in foregone retirement income over the years.
Projecting a much lower income than $72,809 at retirement?
If your combined family income is lower than $32,160 during retirement then you will receive an additional Guaranteed Income Supplement (GIS) amount – $515 or higher per month (at $32,160 or lower). So if you can keep your income lower than $32,160 during retirement (lets say by only claiming Canada Pentation Plan as income), then you stand to benefit considerably from the GIS. Because TSFA withdrawals are not taxable income on withdrawal (unlike RRSP withdrawals), they will not erode your GIS amount.
Therefore there are 3 common scenarios where the TSFA comes out ahead:
- You have higher retirement income between $73,000 and $117,000, and the TSFA helps to reduce OAS claw back.
- You have an income that is lower than $32,160 from other sources, and you can withdrawal TSFAs to provide additional retirement income without disqualifying you from the GIS.
- You have retirement income somewhere in the middle – $32,160 to $73,000 that is consistent with income earned during your working years. In this case there is no benefit between a TSFA and RRSP. There is however a likelihood that the Government will continue to reduce the amount of income that triggers the OAS claw back. So it is a safer bet to invest through TSFAs first, when viewed through a lens of future Federal Government policy making.
When does an RRSP make more sense?
The one situation that sticks out in favour of the RRSP is when retirement income is projected to be substantially less than the income earned during the working years. For example, let’s say you are paying income taxes at a marginal tax rate of 45% during the working years. If you are projecting that income from all sources at retirement (including RRSP withdrawals) will trigger a much lower 25% to 30% marginal tax rate, then this substantial disparity between tax rates can prove the RRSP as a more effective savings tool.
With minimal marginal tax rate disparity, the TSFA can still come ahead due to the points noted above. So the difference in marginal tax rates would have to be significant to be of any real benefit.
3 Options to Run With
Our conclusion leaves you with three options:
(1) Take this information and run with it. By investing in a TSFA before an RRSP, you’ll do well.
(2) Try calculating and determining specifically how you be further ahead using this handy calculator. http://www.taxtips.ca/calculator/tfsavsrrsp.htm
(3) Seek the advice of an experienced financial planner or money coach. They can most accurately show you the difference between RRSPs Vs TSFA based on several projected retirement scenarios.