This post is a continuation of our last post “Time for a (Financial) Fitness Checkup?”. You can read that here.
In one corner we have the RRSP, Canada’s oldest registered savings product with years under its belt and countless supporters. In the other corner, we have a relative newcomer in the market (since 2008), the TFSA. Who will reign?
Well that depends. Like betting on a boxing match, there are so many different variables to consider, but hopefully with the discussion below, we’ll shed some light on the best option for you. Continue reading below.
The following table compares some basic facts about both savings accounts:
| TFSA | RRSP | |
| Tax Treatment |
Tax-exempt account: Contributions are made with after-tax dollars. |
Tax-deferred account: Contributions are made with pre-tax dollars. Contributions lower an individual’s taxable income by the amount contributed. |
| Tax on growth? | No. Contributions are allowed to grow tax free. | No. Contributions are allowed to grow tax free. |
| Tax on withdrawals? | No. Withdrawals out of the TFSA are tax-free (i.e. tax exempt). | Yes. Withdrawals out of the RRSP are taxed at your marginal tax rate at the time of withdrawal. |
| Contribution Limits | Set yearly. Contribution limits raised to $6,000 for 2019 from $5,500. If an individual has never contributed to a TFSA since inception in 2008, the maximum amount of room is $63,500. | 18% of your previous year’s income, up to a maximum amount set by the CRA each year. E.g. for the 2018 tax year, the maximum amount is $26,230. |
| TFSA | RRSP | |
| Do you regain contribution room when you withdraw? | Yes. Contribution room is regained the following calendar year after the withdrawal. | No. With the exception of the First-Time Home Buyer Program (HBP) and the Lifelong Learning Plan (LLP). Further information on this can be found on the CRA website. |
| Other Considerations | You need earned income to contribute to an RRSP, but you don’t with a TFSA. | US stocks that pay dividends are not subject to US withholding taxes if held in an RRSP. |
| Best For | Anyone looking to save for a purchase in the short term, an emergency fund, or retirement, the TFSA is a versatile investment vehicle. | Retirement savings for those who expect to be in a lower marginal tax bracket at retirement, than they are now. If you make less than $45,000 now, then this might not be the best option for you. |
As a very simplistic example, let’s compare the ending value of the TFSA, RRSP, and taxable account, assuming that an initial contribution of $10,000 after-tax is made into each. An individual who is currently getting taxed at an average rate of 30% (marginal tax rate of 43%) would then be able to contribute about $14,300 into their RRSP (initial $10,000 contribution plus the $4,300 tax refund). As per the table above, the contribution limits between the TFSA and RRSP are different, so to compare apples to apples, we will assume that no contributions or withdrawals are made over a 30 year time horizon (i.e. zero cashflow). An average 6% return per year is assumed.
One important thing to note is that many of our current clients have diligently saved over their working careers, contributing regularly into the RRSPs. What happens through the magic of compounding and good savings habits is that their RRSPs have grown from zero, to close to $1 million. Due to this, we will assume for this analysis that both accounts will be entirely liquidated at the end of 30 years, and thus taxed at the highest tax bracket, we will assume 50%.
Here are the results:
|
Account Type |
Future Value, After Tax |
|
Open/Cash |
$34,358 |
|
RRSP |
$41,024 |
|
TFSA |
$57,434 |
It is not surprising that in the absence of taxes, the TFSA will grow to the largest, ending value and the open/cash account will lose the power of compounding due to taxes annually. Because of the over simplification of this analysis, what we fail to consider is the cash flow into and out of the accounts, and the variability of returns due to the market cycles. Both of which can have a significant impact on the final results. We also don’t consider the rate of distribution on the funds when an individual hits retirement age; very rarely does the entire account get liquidated at a single moment and is more likely paid out at 5% – 15% per year.
The analysis is too complicated to do on a general basis since everyone’s financial situation is different, and there is truly no one-size-fits all answer to the question on TFSA vs. RRSP. It is best to work with your financial advisor on the best place for YOU to put your money to meet your investing goals in the long run. The best way to ensure long term growth of wealth is to ensure you have a diligent financial plan, contributing money to your savings regularly, growing the savings rate based on your salary growth, and living within your means.