A key part of your financial strategy involves deciding where to invest. And that brings us to the often asked question, which is better; the Tax Free Savings Account (TFSA) or the Registered Retirement Savings Plan (RRSP)?
As any personal finance expert will say, the answer is both. While that’s excellent advice, and I highly recommend investing in both if you have the ability, some of our readers do need to choose. This can be especially true if you have unused lifetime contribution room on either of the two investment vehicles. If that is the case for you, knowing how to determine which option is better can save you thousands of dollars in your lifetime.
The RRSP is a tax-deferred investment, which means you should be able to contribute more now, because of the tax break. When you retire and start withdrawing the monies, you will pay tax at that time.
When contributing to the TFSA on the other hand, these funds are invested on an after-tax basis. This means you have already paid income taxes on the funds that you invest. As a result, when you withdraw any money, including gains, these proceeds are tax-free.
Let’s look at this a little closer:
Example 1
* Future Value is determined at an annual growth rate of 7.5% over 20 years.
As you can see in Example 1, holding our tax rates constant, both options will result in the same after-tax proceeds. This isn’t an accident, as the two investments were designed this way! At this point, you might be saying, “Okay, this is a rather long way of saying that TFSA’s and RRSP’s are the same.” But wait! Before I lose you, let’s look at the numbers when taxes change. As is hopefully the case as you grow throughout your professional career, you’ll reach different tax brackets.
In Example 2, holding all other assumptions constant, we’ll assume you plan a wealthy retirement, where you withdraw enough each year to be taxed at an average rate of 35%.
Example 2
* We have held our growth assumptions constant, as a reminder: Future Value is determined at an annual growth rate of 7.5% over 20 years.
In example 2 (above), the TFSA wins out. The taxes we paid when we first invested were at a lower rate than when we withdrew the funds in our retirement. What does this mean? If your marginal tax rate now is lower than you expect it to be when you retire, you would be better off using the Tax Free Savings Account (TFSA) to save money. In plain English, think early in your career when your annual earnings are lower. In this instance, investments in your TFSA help you more than in your RRSP.
Now let’s flip the tax equation around. This would be the case if you were established in your career, and your earnings reflect that!
Example 3
* Growth rate 7.5% annually, 20 years.
You guessed it! Registered Retirement Savings Plan (RRSP) investments win out when you pay more taxes now. These investments help reduce the taxes paid on your income at higher rates, and are taxed at lower rates when you withdraw.
Let’s sum it up! If you earn in the same tax bracket that you expect to retire in, the investment options are the same. If you expect to have more retirement income than what you currently earn at, the TFSA is better. Conversely, if you are a high earner right now and plan to retire at a lower tax bracket, the RRSP is financially better.
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Other Considerations:
It is important to note, this analysis does not take into consideration other factors. For example, if you are applying for Child Support, that could change the results of this analysis. Often the subsidies available are higher at lower income levels, meaning the RRSP could be the better option to reduce taxable income and qualify for higher child support payments/ assistance.
There are also restrictions on annual and lifetime contribution limits for both RRSP and TFSA. We’ll cover those in other articles, so you can make better informed financial decisions.
On top of those contribution limit restrictions, there are also tax events that can change the outcome of this analysis. For more information on what types of investments should be stored in which account, look to the Foreign Taxes section below.
And finally, any employer matching changes the results too. As a general rule, if you are lucky enough to have employer matching for either RRSP or TFSA, it is almost always best to take full advantage of those programs.
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Foreign Taxes:
To add some extra complexity to our analysis of the RRSP and TFSA investment accounts, the Canadian government signed some tax treaties with foreign governments. To limit the scope of our article, and to prevent some overwhelm, we'll restrict our look to investments in US based companies (traded on US stock markets). US investments are chosen specifically, as the US houses the largest trading market in the world. As a Canadian investor, it's likely some of your investments will be domiciled in the USA.
Any dividend income received from an investment is subject to foreign withholding tax, of 15% or more, depending on the country. For our US investments, the tax rate is 15%.
When you store those investments in an RRSP, those withholding taxes aren't applicable. When the same investments are held in a TFSA, the taxes are applicable.
What this means is that if your portfolio is built to capture dividend gains, those investments are best stored in your RRSP, to minimize the withholding taxes paid.
Where are you in your career? What type of investing do you focus on?
The answers to those questions directly impact which style of investment account you should focus on, and what investments belong where. The right investment decisions made now will serve you profitably on your financial journey.