FP Answers: Should I invest in a TFSA or RRSP? And when does it make sense to do both?

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Personal Finance Family Finance

Whether you make less than $45,000 a year, or more than $220,000, there are some key points to consider when deciding where to put your money

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Feb 10, 2022 • Feb 14, 2022 • 6 minute read • 14 Responses How do you decide between money in a TFSA or an RRSP? How do you decide between money in a TFSA or an RRSP? Photo by Mike Faille/National Post artwork files

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By Julie Cazzin with Allan Norman

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Q: This is the time of year when I always look at the money in my savings account and try to determine if I have enough to make a Registered Retirement Savings Plan (RRSP) or a tax-free savings account (TFSA) contribution. With two kids and a mortgage, money is often tight and I can only do one or the other. How do I determine what is best for me? And if I ever have enough money to do both—something that will likely happen shortly after my mortgage is paid off—is there any point in doing that? — Leona

FP answers: That’s a good question, Leona, and I know from experience that many people have this conundrum. But it all starts with understanding the math. There are other factors involved, but knowing the math will go a long way in making your decision.

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Before we get into the math, remember that an RRSP contribution is pre-tax and withdrawals are taxable, while a TFSA contribution is after-tax and withdrawals are tax-free. This is an important distinction, as you will see shortly.

An RRSP also offers you a tax refund, which you should think of as an interest-free loan that you can do with whatever you want, but must be repaid when you withdraw from your RRSP or Registered Retirement Fund (RRIF).

Now, to the math.

The accompanying table compares the after-tax results of investing in an RRSP with a TFSA investment earning five percent over 20 years. Which investment account do you think will do better assuming your marginal tax rate (MTR) stays the same?

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The answer is in row six: if your MTR remains the same and both accounts earn the same interest rate, there is no difference between investing in an RRSP or TFSA.

Row seven shows that if you have a lower MTR at the time of withdrawal than when you contributed, the RRSP beats the TFSA. Many people will find themselves in this situation when they retire or if they are part of a married couple and can split retirement.

Row eight shows the opposite. If your MTR at the time of withdrawal is higher than at the time of insertion, then the TFSA is better.

Row nine probably represents most people’s estate taxes. In Ontario, your MTR is 53.53 percent if you have taxable income or assets over $220,000. Just a reminder that not all income is taxed at 53.53 percent — just income over $220,000.

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To avoid the big tax bill, it can make sense to take excess income from your RRIF, even if you don’t need it to support your lifestyle. That shouldn’t be a problem if your MTR was 40 percent at the time of insertion and 40 percent at the time of withdrawal. The math says it’s no different than if it was a TFSA investment (although Old Age Security (OAS) reclaim could be a problem).

The problem is you need another investment tax shelter. If you’re taking excess income from an RRIF, you probably don’t need it – it’s a surplus. If you have children or grandchildren, consider contributing to their Registered Education Savings Plans (RESPs), TFSAs, or RRSPs.

That’s the textbook explanation of RRSP math, but let’s get realistic.

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Notice in row three that the RRSP investment was $7,142 (that’s pre-tax) and the TFSA investment was $5,000 after tax. That’s the right way to make the comparison, but is that how most people invest? If you have $5,000 to invest in an RRSP or TFSA, don’t think, “How much did I have to make to get my $5,000?” and then contribute the larger gross amount to your RRSP?

Most people don’t.

Here’s the formula to do the calculation, if you’re interested: iinvestment amount/(1-MRT) = profit before tax†

Also keep in mind that a small RRSP loan is a good strategy to increase your RRSP investment. Pay off the loan when the RRSP tax refund comes.

If you don’t use the loan strategy, some investors will invest the RRSP tax refund, but the $5,000 tax refund is less than the gross amount, so it’s not as effective as increasing your initial investment.

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The second table shows the after-tax results of investing the same amount in an RRSP or a TFSA and investing the payback versus not investing the payback.

As you’ve probably guessed, in almost all cases, investing in a TFSA is best. The minor exception can be seen in row three, when the RRSP tax refund was invested and the MTR at the time of withdrawal was lower than at the time of contribution.

At this point, you may be wondering why you should ever consider investing in an RRSP. One reason is that you can contribute more to an RRSP than to a TFSA, but here are some other important things to consider based on income alone.

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Income of less than $45,000 and an estimated MTR of 20 percent

The TFSA is probably the best option because your MTR for withdrawal is unlikely to be lower than your MTR at the time of contribution; your tax-free withdrawals at retirement will not negatively impact government benefits such as the Guaranteed Income Supplement (GIS), or tax credits such as the age credit; if you start investing young enough, the maximum TFSA contribution limit is probably all you need to save to support your current lifestyle after retirement, when combined with Canada Pension Plan (CPP) and OAS.

An exception may be if you’re trying to lower your taxable income to claim more Canadian child support (CCB).

Income between $45,000 and $90,000 with an estimated MTR of about 30 percent

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This is the may/may not be the scope for RRSP contributions. Are you going to increase your RRSP contribution? How much should you save for your retirement? Is it more than what the TFSA contribution limits allow? Will your MTR get lower when you retire?

In general, most people in this income range will contribute to RRSP accounts. The higher your income in this range, the more logical the RRSP contributions will be.

If you’re just above the $45,000 income or MTR level, consider contributing only enough to an RRSP to put you in the lower tax bracket.

Income of more than $90,000 and an MTR of more than 40 percent

At this income level, your focus may be on maximizing your RRSP contributions and using up all previous RRSP contribution space before making TFSA contributions. One goal may be to catch up on your RRSPs and then use the tax refunds to maximize your TFSA.

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There are many other factors to consider, including income distribution, the RRSP Home Buyers’ Plan and Lifelong Learning Program (LLP), and the impact on government benefits and credit.

My suggestion is that you discuss your situation with a planner if you are unsure whether you should contribute to an RRSP or a TFSA. Or decide what seems best to you for your situation and contribute to one of those plans. You won’t make a bad decision and it’s better to contribute to either one rather than doing nothing at all.

Allan Norman, M.Sc., CFP, CIM, RWM, is both a Certified Paying Financial Planner at Atlantis Financial Inc. and a fully licensed investment advisor at Aligned Capital Partners Inc. He can be reached at www.atlantisfinancial.ca or alnorman@atlantisfinancial.ca. This comment is intended as a general source of information and is intended for residents of Canada only.

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This post FP Answers: Should I invest in a TFSA or RRSP? And when does it make sense to do both?

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