It’s the match up of the century! The heavyweight fighters for your money. When it’s time to choose a winner, many of us just don’t know which one to pick. For the most part, the best one for you really depends on the financial goals that you want to set for yourself.
As I have written before, the TFSA and the RRSP are very similar in nature. The RRSP savings account might seem like the best choice because it pretends to give you money back right away when you make a contribution. Most people will generally choose the RRSP because of this reason. It is common for someone to receive their RRSP tax “refund” from the mail and go off and spend it on an expensive purse or the latest iPad. Instant gratification is great! We want results and we want it now. Many of us lack the patience to see our money grow and this often leads to rash quick decisions. It may seem like a bonus when you receive your “refund”, but remember you do have to pay back a little bit of those taxes when you take your money out of the RRSP account.
Let’s take a look at a small example:
The assumption here is that you invest $1000 and keep it invested for 3 years at a rate of 5%. Your marginal tax rate at investment and withdrawal is 22%. Here is what it might look like in this scenario.
Whoa! This might surprise many when they see this because it seems like the TFSA pulls out ahead unless the refund is put back into the RRSP. This is true because the nature of the RRSP is to serve as a tax deferral and such it doesn’t give you any extra money back. In fact, given the many practices of people using their refunds on other purchases and not reinvesting, it would seem to be a better choice to put your money in the TFSA and not have to worry about the refund at all.
So is the RRSP dead? Should I avoid it completely? Well….no. This is where careful planning is required. For some, when you take money out of your RRSP, it might not get taxed at all because you could be making very little money in retirement, or you withdrew the money when you were unemployed for the year. The RRSP will beat the TFSA if you expect your marginal tax rate to be lower than when you made your RRSP contribution. This could be true for high income earners that are in the 29% marginal tax brackets. When you retire you may fall down to a lower tax bracket. This is when it makes sense to invest in your RRSP account over the TFSA.
Let’s take a look at another example where $1000 is invested but your marginal tax rate is currently at a higher 29% and when you retire you income falls to bring you back to 22%.
Notice how the RRSP will actually help you save taxes in this situation and pull out ahead if you put your refund back into the RRSP account. Reinvesting the money you get back from the RRSP is extremely important in either case. Otherwise putting money in the TFSA is still the better option.
If you are dreaming big and thinking you’ll have millions in the bank because you are going to become a huge entertainment celebrity, then the RRSP is not for you. You’ll get taxed to death when you take your money out, and besides, you’ll have less money to invite me to your retirement party for giving you great financial advice.
One other thing to note is how a pension might affect your decision. If you are a government worker and will retire one, you may want to reconsider putting too much money into an RRSP. Some government pensions will pay up to 90% of your income based on the last 5 years of service. If you make over $100k and you’re expecting to have a pension in the $80-$90k range, then watch out! The money you withdraw from your RRSP could end up getting taxed at the highest tax bracket! Imagine those dollars you used to put into your RRSP around age 30. You might have been making only $50k, where your marginal rate was only around 20%. All of a sudden you’re paying 50% more tax!!
When all the numbers are said and done, there is no reason why the TFSA and RRSP can’t work together. If you are a keen saver, then maxing out your TFSA and further making small contributions to your RRSP will help you build an even bigger nest for retirement. The $5500 limit on the TFSA will hamper your ability to save for comfortable retirement. Using the RRSP will help considerably. For the majority of people, the TFSA is something you’ll want to consider. If you’re spending your “refund”, or don’t fall into a high marginal tax bracket, the TFSA will put you ahead of the RRSP in the long run.