In 2009, the federal government introduced the Tax-Free Savings Account (TFSA) as a new, registered savings plan available to Canadian residents aged 18 or older. It was introduced as a complement to its older, more familiar counterpart the Registered Retirement Savings Plan (RRSP). While both plans offer attractive advantages to investors seeking more favourable tax treatment for their savings, each one offers something unique.
So when I meet with clients who have money to invest, I’m often asked which of the two plans makes more sense for them. And my answer, almost always, is “it depends.”
While I know that’s not a particularly definitive response, there are pros and cons involved with both plans. And what I always go on to explain is that the answer to the “RRSP or TFSA” question often depends on how badly somebody wants a larger tax refund in the spring. If they are OK with not receiving a larger return – and are more concerned with using this money during their retirement – I’d recommend the TFSA. If they definitely want a larger tax refund next year, the RRSP is usually the way to go.
Here’s why I say this.
One of the main reasons Canadians like RRSPs is that they allow you to deduct contributions you make to that plan from your earned income that year. This usually leads to a larger income tax refund the following spring, an advantage TFSAs don’t offer. So if you contribute $10,000 to an RRSP and you’re in a 40% marginal tax bracket, your refund should be $4,000 larger than it would have been otherwise.
But here’s the fly in the ointment. When you withdraw that money during retirement, you’ll need to report all withdrawals as income, fully taxable at your marginal rate.
So let’s say over the next 25 years, your initial $10,000 investment grows to $40,000. And you withdraw that $40,000 during your first year in retirement.
If that money was originally invested in an RRSP, you’ll have to report all $40,000 as income in the year you withdraw it. So if you’re still in a 40% tax bracket in your first year of retirement (which is possible), you’ll only keep about $24,000 of it. Plus, the fact you’re reporting more income may affect the amount of Canada Pension Plan or Old Age Security benefits you receive during retirement.
If that $40,000 was originally deposited into a TFSA, you won’t have to report a dime of it as income. That’s the advantage TFSAs do offer; withdrawals are completely tax free. When you withdraw $40,000, you keep $40,000.
So for many people, the answer to the RRSP vs. TFSA question really boils down to whether they can do without the initial refund if it means being able to keep much more of your money during retirement. If you’re not too enticed by the thought of getting a larger refund – which most of us spend immediately anyway – then it often makes more sense to go with the TFSA.
However, this is just a simplified version of the pros and cons to the two accounts. There are other facets to this debate as well. For example, for people looking to buy their first home, they can withdraw up to $30,000 from their RRSP to use towards the purchase without paying tax immediately. So for those people, sometimes the scales get tipped towards the RRSP. However, the TFSA offers a bit more flexibility in that any money withdrawn from the plan can be recontributed the next year – a feature the RRSP does not offer.
If you’d like to know more about what I’ve written about here, I’d be happy to chat with you.
Mark McDonald
You can reach me any time at [email protected] or by phone at 905-617-1930.