Should you contribute to a RRSP or TFSA? (Part 2)

Hand drawing money sign, "Where to Invest"

TFSA vs RRSP?

Last month I talked about when to use the RRSP vs TFSA. This week I will touch on this topic further.

RRSP’s are optimized when you make contributions when your tax rate is high, with the strategy to withdraw these funds at a later date (like retirement) at a lower tax rate.

Let’s take a deeper dive into this.

Suppose you earn $75,000 per year today. Making a $1000 contribution this year will save you $296 in taxes (29.65% tax rate). When you retire and you have a smaller income (for example, $40,000), you will pay $200 in taxes (20% tax rate) on a $1,000 withdrawal.

This tax savings can be further magnified by the fact that your original $1000 contribution has gained value since it was initially purchased. (The ‘time value of money’ effect)

During retirement, seniors have the ability to split income, including pensions and RRSP/RRIF accounts once over age 65. This can generate significant tax savings.

So why a TFSA then?

TFSA’s are an additional option to help Canadians save that is tax deferred. If you are in a high marginal tax rate, you will want to utilize the RRSP first. If your tax rate is low now, and you expect it to be higher in retirement than it is today, a TFSA is your best option.

All things being equal, if your tax rate never changes from now into retirement, than it makes no difference which one you choose (at least from a tax planning perspective)

The following illustrates this point.

TFSA vs. RRSP

(Notice the after tax outcome after 20yrs is identical when tax rates stay the same)

Source: Investment Planning Counsel, http://www.deferthetax.ca/rrsp_vs_tfsa

 

I would caution you when looking at these options to ask yourself what the intended purpose is for these funds? Tax savings today do have consequences in the future. The TFSA offers tremendous liquidity and the ability to take funds out and re-contribute back in. Once you access funds from an RRSP you can’t re-contribute unless you have RRSP room available.

Although these plans don’t seem overly complicated, making the right decision on how to build them is critical to their success. Mastering the basics is a good start, but seeking the advice of a qualified Financial Planner/Advisor can make a big difference down the road.

Grant Galloway, CFP, CLU, CHS

Financial Planner