Where to put your Savings – RRSP or TFSA?

It’s not always easy deciding where to put your savings.  Tax time is approaching, and investors must decide whether to make a Registered Retirement Savings Plan (RRSP) contribution.  At the same time you’re given a further amount that you can contribute to your Tax Free Savings Account (TFSA).  Also in the mix is whether or not to apply savings to reduce your mortgage if you still have one.

The Tax Free Savings Account (TFSA) has some amazing features that make it attractive and flexible, but the majority of people are not yet utilizing the TFSA, likely because of limited savings.  The Tax Free Savings Account started in 2009 when the annual contribution limit was set at $5,000.  However, effective in 2013, the new annual contribution limit is $5,500.  For those individuals who have not yet contributed to a TFSA, and were 18 years or older in 2009, the total accumulated amount that can be put into a TFSA now is $25,500.

The maximum RRSP contribution limit for 2012 and 2013 is $22,970 and $23,820, respectively.  The decision on whether to contribute to a TFSA or an RRSP is primarily focused on your current income and your future expected income.   We will use three different people, approximately 50 years old, to illustrate different outcomes assuming both the TFSA and RRSP are invested for twenty years and compounded growth of four per cent.  We will assume that each individual is considering a $20,000 RRSP contribution.

■ Mr. Wilson is in a high income tax bracket now (40 per cent) and he feels that he will also be in the same high income tax bracket in twenty years when he enters retirement.  For the current year, the $20,000 contribution would reduce Mr. Wilson’s current income tax liability by $8,000.  If Mr. Wilson didn’t contribute to an RRSP he would have $12,000 ($20,000 current savings less the $8,000 additional tax for not making an RRSP contribution) to invest in a TFSA.  Let’s look at the value of both the RRSP and TFSA funds after 20 years.  The TFSA would be valued at $26,293 and the RRSP would be valued at $43,822.  At first glance, the RRSP seems better, but it’s not – they are equal.   TFSA withdrawals are not taxable.  If Mr. Wilson is in the 40 per cent income tax at retirement (same tax rate as when he contributed initially) then any withdrawal from his RRSP is also subject to 40 per cent tax.  If Mr. Wilson withdraws $43,822 from his RRSP, then $17,528 is payable in tax and the net amount of $26,293 is equal to growth in the TFSA.   These are equal because Mr. Wilson’s income tax rate did not change at the time of contribution and at retirement.

■ Mr. Baker is in a high income tax bracket now (40 per cent) and he feels that he will be in a lower income tax bracket (20 per cent) in twenty years when he enters retirement.  For the current year, the $20,000 contribution would reduce Mr. Baker’s current income tax liability by $8,000.  If Mr. Baker didn’t contribute to an RRSP he would have $12,000 ($20,000 current savings less the $8,000 additional tax for not making an RRSP contribution) to invest in a TFSA.  Let us look at the value of both the RRSP and TFSA funds after 20 years.  The TFSA would be valued at $26,293 and the RRSP would be valued at $43,822.  Similar to Mr. Wilson above, the TFSA withdrawals are not taxable.   If Mr. Baker’s marginal income tax rate drops to only 20 per cent at retirement (half of what the rate was when he contributed initially) then any withdrawal from his RRSP is subject to 20 per cent tax.  If Mr. Baker withdraws $43,822 from his RRSP, then $8,764 would be the estimated tax and the net amount of $35,058 is higher then the TFSA balance of $26,293.   The RRSP option is better because Mr. Baker’s income tax rate was high when he contributed to an RRSP and was lower when he withdrew the funds from the RRSP.

■ Mr. Watts is in a low income tax bracket now (20 per cent) and he feels that his income will rise in the future and he will be in a high income tax bracket in twenty years when he enters retirement.  For the current year, the $20,000 contribution would reduce Mr. Watt’s current income tax liability by only $4,000.  If Mr. Watts didn’t contribute to an RRSP he would have $16,000 ($20,000 current savings less the $4,000 additional tax for not making an RRSP contribution) to invest in a TFSA.  Let us look at the value of both the RRSP and TFSA funds after 20 years.  The TFSA would be valued at $35,058 and the RRSP would be valued at $43,822.  Although the RRSP is still higher in 20 years, Mr. Watt’s income tax bracket has increased to 40 per cent.   Again, TFSA withdrawals are not taxable.  If Mr. Watt’s is in the 40 per cent income tax bracket at retirement (a higher tax rate then when he contributed initially) then any withdrawal from his RRSP will be subject to 40 per cent tax.  If Mr. Watt’s withdraws $43,822 from his RRSP, then $17,529 would be the estimated tax and the net amount of $26,293 would be lower than the TFSA amount of $35,058.

■ The decision between the mortgage and TFSA is fairly easy.  If you have a mortgage then I generally advise for the conservative approach of completely paying off the mortgage prior to contributing to a TFSA.  As noted above, the contribution limit accumulates so that you can contribute to your TFSA once your mortgage is paid off.  The sooner you get rid of paying non-deductible interest costs on your mortgage the sooner you’ll be able to make bigger leaps in your retirement savings.  The focus should always be on your net worth.  At the end of each year, ask yourself if your net worth has moved in the right direction.  Increasing your assets (i.e. investments) or reducing your liabilities (i.e. mortgage) will increase your net worth.

■ The decision between the mortgage and RRSP is not as easy as the TFSA.  The best option for high income individuals in the top income tax bracket is generally to contribute to an RRSP and then immediately use the tax savings to pay down the mortgage.   If you do not have a mortgage then you should consider contributing to both an RRSP and a TFSA if cash flow permits.  This strategy works very well if your income tax rate is high today, especially if your income is expected to be lower at retirement.