Which is better? RRSP vs TFSA

RRSP vs TFSA

   It’s tax time, which means we’re taking a much needed look at our current finances. While we’re looking at our finances, this provides a great opportunity to make adjustments for our 2019 financial strategy. Part of that 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

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

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.

   Now let’s flip the tax equation around. This would be the case if you were established in your career, and yours earnings reflect that!

Example 3

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.

   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.

Return on Investment, Your Investment

   Return on Investment, or ROI, is a fairly common term used when investing. Simply put, you desire a positive growth on monies invested over time. This could be interest income on a loan you made, your house increasing in value, or the stock market paying dividends and increasing in value.

 

   Now we’ll look at the other aspect of ROI, the ways we don’t commonly associate the term. I’m talking about the decisions that you make every day. The decisions that involve some level of financial, time, or energy commitment from you. These are all finite resources in everyone’s life, and while financial elements receive more attention, your time and your energy are even more scarce. And unlike money, when they run out, you can’t get more at the local store. It is this scarcity that drives the need for each decision you make to bring you a positive Return on Investment.

 

   Sounds great, right? But how does this actually look in yours and my daily lives? It’s heading to the gym when you’d rather skip today. It’s saying no to that extra beer or two to make sure you can get out of bed tomorrow without holding your head. It’s flicking the TV off a half hour early so you can read and improve your knowledge and communication. Or not putting yourself in the position to make an impulse purchase that you’ll regret later. It's checking in with the important things in your life to make sure you’re building on a strong foundation.

 

   It is these little successes every day that build into a long-term positive Return on Investment, your investment in you, your life. So go on, make the choices today that leave you wealthier, happier, and healthier tomorrow.