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RRSP or TFSA? Here’s the simple and definitive answer

We’re now in the early stages of RRSP season, the time of year when Canadians traditionally focus on tax-advantaged saving for retirement. In large part, it’s driven by the advertising and sales lead-up to the annual RRSP deadline, which this year falls on March 2.

But it’s important to realize that RRSPs aren’t your only choice. The government offers two great options for tax-advantaged saving for retirement. In addition to the long-established RRSP (Registered Retirement Savings Plan), there’s also the more recent TFSA (Tax-Free Savings Account), started in 2009. Since they work differently, that naturally leads to the question of which should you contribute to if — as is pretty common — you only have enough money to do one and not both.

The short answer is this: If you have to choose between the two, the RRSP is the ideal option in a common but specific set of circumstances. That generally applies when you’re investing long-term for retirement, you’re in a reasonably high tax bracket now when you contribute, and you expect to enjoy a typical middle-class retirement in a somewhat lower tax bracket.

The TFSA is more of an all-purpose savings vehicle that has the advantage in most other situations, whether investing long-term for retirement or for a shorter-term goal.

Now let’s delve into the details.

Both RRSPs and TFSAs shelter you from tax on interest, dividends and realized capital gains on your investments while the funds stay within the account.

With an RRSP, you get a tax deduction up front from making a contribution — generally resulting in a tax rebate — but all the money becomes fully taxable when you eventually take it out. The TFSA is the opposite: you don’t get a tax rebate on contributions, but you don’t pay tax on withdrawals either.

So if you’re choosing between the two, in large part the choice boils down to whether you should pay the Canada Revenue Agency (CRA) now (as you do with the TFSA, since there is no tax rebate) or later (as you do with the RRSP because withdrawals are taxed).

Which choice saves you the most tax depends critically on your tax rate now versus later. If you’re in a higher tax bracket when you put the money in than when you take it out, then you get a bigger tax break with the RRSP. If you take the money out when you’re in a higher tax bracket than you are now, then the TFSA has the tax advantage.

If your tax rates are the same when the money goes in and then comes out, then the tax impacts are equivalent. (Note those results assume you also invest your RRSP tax rebate — normally into your RRSP as well — rather than just spend it on your lifestyle.)

While figuring out which is better is fairly straightforward in concept, putting it into practice is more difficult.

After all, it’s hard to predict what tax bracket you’re going to be in decades from now. But, although you can’t know now for sure, most people live on far less income in retirement than at the salary-earning peak of their working years. So, RRSPs make a lot of sense in the common situation where you’re currently earning a fairly high salary and you’re saving for a typical middle-class retirement.

But there are many other situations where you’ll fare better with a TFSA.

To start with, the TFSA is far more flexible. Dipping into a TFSA never has a tax impact, whereas you can expect to receive a big tax bill if you need to draw on your RRSP for a sudden need while you’re still earning a good salary that puts you in a high tax bracket. (You can take out specified amounts from your RRSP without tax consequences for a first-time home purchase or for education, but you have to repay those amounts back into your RRSP according to rigid timetables or count the money as income and pay tax on it.)

Also, dipping into an RRSP results in permanent loss of the contribution room, whereas you can put back the money from TFSA withdrawals after waiting until the next calendar year.

In addition, you’re forced to convert your RRSP to a Registered Retirement Income Fund (RRIF) or annuity by the year you turn 71 — and then you have to make mandated minimum withdrawals starting the following year. In contrast, TFSAs come with remarkably few strings attached when it comes to withdrawals.

So if you’re looking for flexibility — and especially if you might need the money while still working — the TFSA is the clear winner.

The scales also tilt in favour of the TFSA if you’re among the minority of people who end up in a higher tax bracket in retirement. Complicating the picture is the need to factor in the potential impact of clawbacks on key seniors benefits that are sometimes triggered by RRSP and RRIF withdrawals. Oddly, these kinds of benefit clawbacks don’t typically affect middle-income seniors that much, but they have a far greater impact if you have either a high or low income as a senior.

Bottom line

If you have to choose between an RRSP and TFSA contribution, go with the RRSP if you’re in a fairly high tax bracket now, expect to be enjoy a typical middle class retirement in a lower tax bracket, and are pretty confident you won’t tap the funds before you retire. Otherwise, go with the all-purpose and flexible TFSA.

Know your contribution limits

You need to be aware of your RRSP and TFSA contribution limits, since you generally pay hefty financial penalties if you exceed them. However, it is pretty common for middle class contributors to accumulate more unused contribution room than they will ever manage to use. For both RRSPs and TFSAs, you get additional contribution room each year, but you also accumulate unused contribution room from previous years.

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For RRSPs, you can contribute up until March 2 of this year and still have the contribution generate a tax deduction against income on your 2019 tax return. For TFSAs, contributions count in the year they happen.

The annual additions to RRSP contribution room are based on 18 per cent of earned income from the previous year (minus adjustments for employer pension benefits if any) to a maximum contribution of $26,500 for 2019. The annual addition to TFSA contribution room is a set amount each year ($6,000 for 2020) which is available to all Canadian residents 18 years and older.

Your online CRA account tracks your unused contribution room for both your RRSP and TFSA. You can also get your unused RRSP contribution room from your CRA Notice of Assessment.

David Aston
David Aston, a freelance contributing columnist for the Star, is a personal finance and investment journalist. He has an M.A. in economics and is a Chartered Professional Accountant. Reach him via email: davidastonstar@gmail.comLater this month, David will publish his new book, “The Sleep-Easy Retirement Guide,” available at bookstores across the country.
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