RRSP or TFSA - Where should I invest?

I'd have to think this is one of the most common questions we see from a clients. Before we go into what account might work best, let's take a look at each type of investment account and understand some of the key fundamental differences.

RRSP

The RRSP is an investment account that allows you to reduce your taxable income each year, while building up tax deferred savings for future retirement. When you contribute to an RRSP your taxable income that year is reduced by the amount you contributed in the form of a tax deduction. Important to know that the full benefit of contributing to an RRSP can only be reached if the tax savings from your deduction end up invested in your RRSP account (many people spend their tax refund).

Any interest, dividends, or capital gains incurred in your RRSP will not be taxed.  Taxes however will be paid when you take money out of your RRSP.  Any money withdrawn is considered 'income' and will be taxed at your marginal tax rate.  The idea is that during retirement you'll likely be in a lower tax bracket than during your working years, and that the taxes paid on the income received from your withdrawals will be less in retirement.  As I'll highlight later it doesn't always work out that way.

Contribution amounts 18% of your earned income from the previous tax year. For most people, earned income for RRSP purposes is the amount in box 14 of their T4 slips. Earned income also includes self-employed net income, CPP/QPP disability payments and net rental income, OR The maximum annual contribution limit for the taxation year ($27,230 in 2020) MINUS any company sponsored pension plan contributions (defined as PA, or short for pension adjustment on your T4 slip. A PA represents the value of any pension benefits accruing from participation in a registered pension plan or deferred profit sharing plan) It's important to note that contribution room that goes unused does build up and can be used in future years.  It's also important to note when you take money out of your RRSP, the contribution room is never added back.

TFSA

The TFSA is an investment account that allows you to invest with no tax altogether.  The TFSA does NOT provide a deduction which means contributions are made with after tax dollars. Any interest, dividends, or capital gains are earned tax free in the account.  When you withdraw money, this amount also comes out tax free. Contribution Amounts The Tax-Free Savings Account (TFSA) contribution limit for 2020 is $6,000, remaining the same as 2019. If you have never contributed to a TFSA and have been eligible (18 years of age or older) since its introduction in 2009, your cumulative contribution room will be $69,500 in 2020. Important to note that withdrawals from your TFSA in the year will be added back to your TFSA contribution room at the beginning of the following calendar year.

So what's better? Tough question to answer.  It really depends on your tax rate now and expected tax rate during retirement, both of which are unknown making it a difficult task to determine which account will mathematically make better sense today.  You have a math equation that is ultimately missing one of the variables needed to arrive at an answer.  Just because we're missing a variable doesn't mean we can't make an informed guess. Let's look a little more at details.

*Appendix has been provided to show the effects tax rates today and in retirement have an effect on which account is likely better.

Lower Tax Rate in Retirement

While it's impossible to know for sure, most people live off of less income in retirement than they earned in their peak working years. RRSPs can make a lot of sense in the many situations where this is the case. In particular, they provide outstanding results if you're a high-income earner saving for a typical middle-class retirement. (See Appendix - Scenario 2.A)

If you're in a higher tax bracket now versus when you retire, doing the math suggests the RRSP becomes the best choice.  This is due to the fact your RRSP contributions receive a juicy tax rebate now, with CRA taking a smaller cut down the road when you actually take withdrawals for retirement. Withdrawals in this example are expected to be taxed at a lower tax rate, keeping more in your pocket. Pretty straightforward so far.  But not every single client we deal with expects to be at a lower tax rate in retirement.

Higher Tax Rate in Retirement

Many of our clients expect to work longer and at the same time are continuing to build large businesses that will provide high levels of income even throughout their retirement years. We also see a number of individuals who expect to receive large pension incomes throughout retirement.  Whether it's income from a business, rental income, or a pension, these type of situations can put you in a position where your income in retirement ends up being higher than during your working years.

Being in a higher tax bracket in retirement changes the math behind the debate.  You're often better off paying tax today, then to be forced to pay tax on withdrawals in those later years at a much higher rate.  Paying tax today means you receive no tax deduction as your contributions will be directed towards your TFSA. Inside the TFSA you'll receive the same tax deferral as an RRSP, with the added advantage of being able to withdraw proceeds tax free in retirement.

Another key consideration with an RRSP is that you're forced to convert it to a RRIF by the end of the year you turn 71.  Once converted you'll be forced to begin taking minimum withdrawals which will be taxed as income.  If you're already in a high tax bracket this likely means you end up paying way more tax than you had maybe expected. At the same time, it can have an effect on certain government benefits like Old Age Security which is clawed back at certain income levels.  In the situation where your tax rate is higher in retirement, the TFSA will leave more cash in your pocket without creating any government claw back situations.

Before you go rushing to make a contribution based on the math we've just covered, I should mention that other considerations beyond math should be factored into the decision on which type of account is best.

Short-term Versus Long-term

When I'm asked the question of TFSA or RRSP, my first counter question is 'what are your intentions with this money?'  By having a better idea of what the money is for, we're better able to determine when you'll need it. For short term goals, TFSAs can provide a lot of flexibility.  You're able to contribute and withdraw without any tax consequences.  The amount you withdraw can also be recontributed the following calendar year.  This is not the case for RRSPs, as withdrawals are not added back to any previous contribution room.

In certain situations, you can withdraw from an RRSP without triggering any tax.  The First Time Home Buyers Plan and the Lifelong Learning Plan both allow withdrawals without tax consequences.  Although with these type of RRSP withdrawals, there is a period where you must recontribute the amount withdrawn over a certain period of time, otherwise CRA will force you to pay tax on money withdrawn.

Generally speaking, I recommend any money contributed to RRSPs should be done so with the mindset that the money is intended for long term retirement savings.  With short term goals I find our clients prefer the flexibility that a TFSA provides.

Does your employer offer a group RRSP with matching contributions?

Another important consideration is whether your employer offers some sort of group RRSP or work-place retirement savings plan?  Often employers offer group RRSPs where they will match a certain percentage of your contributions, up to a maximum amount.  If this is the case, you really should direct some savings toward your Group RRSP.  If possible, take advantage of the maximum amount your employer offers.  Free money trumps the option of the TFSA every time.

Do you re-invest RRSP contributions tax savings?

The RRSP provides the amazing tax deduction, providing the feeling that you're getting money back.  What's important to remember is that the money you receive is just your own before tax dollars, and that at some point it will be taxed.  Without investing the tax savings from your RRSP contribution back into your RRSP, the TFSA ends up becoming the leader no matter what.

Balance is Key

Some situations will have a clear answer as to which account is better or worse. For others there will be additional considerations that will need to be made in order to figure out which account is right for you. We've found that working with our clients, if the answer isn't entirely clear (often it's not), that a balanced approach with money being invested in your RRSP and TFSA ends up being a good practice. It allows for a balance between short term and long-term goals, and also adds flexibility to your plans in the future. With clients who are in the fortunate position to max out both options, we often recommend doing so.  The more time on your hands, the more deferring tax becomes beneficial.  You'll end up having to pay tax at some point on those RRSP contributions, but likely with a lot bigger nest egg to draw from.

In closing it's important to consider a number of factors before making the decision on which account is best for you.  Too many times I've heard prospective clients say, 'my advisor says the RRSP is better' or 'they said only use my TFSA'.  There is a good chance the advice you receive is not optimal if your advisor is not educating you about the pros and cons of each account, or is not asking questions that help to provide a better understanding of your goals and intention for the money.  If you think this is the case, don't stress.  Saving versus not saving is always better and it's never too late to begin working with an advisor who will help to optimize your financial plan.

- Brandt Butt, Investment Advisor, CIM

Brandt Butt is an Investment Advisor at Endeavour Wealth Management with Industrial Alliance Securities Inc, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.

This information has been prepared by Brandt Butt who is an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.