As the TFSA accumulates more value, are RRSPs even relevant anymore?

National Post

2016-01-06


This year’s RRSP contribution deadline is Feb. 29, meaning that if you want to claim a deduction on your 2015 tax return, you need to make your contribution by midnight on that date.

But the bigger question is: should you even bother?

Quite simply, for many Canadians attempting to save for retirement, a TFSA may be the better option. The amount you can contribute to a TFSA is based on your “TFSA contribution room.” If you were 18 or older in 2009 and, as of 2016, have not yet opened up a TFSA, you can immediately contribute up to $46,500 to a TFSA, consisting of $5,000 of accumulated room for each of 2009 through 2012, $5,500 for 2013 and 2014, $10,000 for 2015, and the recently-reduced $5,500 limit for 2016.

Choosing between the RRSP and the TFSA essentially comes down to comparative tax rates. The two plans are meant to be tax-neutral, if your tax rates remain the same.

Consider Isaac who has $5,000 of gross income to save, pays tax on it when it’s earned at his (assumed) marginal rate of 40 per cent, leaving $3,000 to be invested in a TFSA. Since the earnings and growth inside the TFSA are neither taxed during the accumulation phase, nor taxed upon ultimate withdrawal, the net after-tax value after 20 years, assuming a modest three per cent compounded annual growth rate, would be $5,418.

Contrast this with Jake, who also has $5,000 of gross income to save, but contributes the entire amount into his RRSP. He won’t have to pay tax on these earnings currently since he will get a tax deduction on his return for the amount of his contribution. As a result, the full $5,000 is invested in his RRSP, grows to $9,031 (also compounded at a three per cent rate of return) and is ultimately taxed in 20 years’ time at 40 per cent, netting Jake exactly the same after-tax amount as Isaac, or $5,418.

It’s only when your tax rate upon ultimate withdrawal is lower or higher than your current tax rate that either the TFSA or RRSP wins out.

RRSPs make more sense when your tax rate upon withdrawal is expected to be lower than the tax rate upon original contribution. You might even consider withdrawing funds on a tax-free basis from your TFSA and contributing the proceeds to your RRSP. You could then re-contribute the amount to your TFSA in a later year once your RRSP contributions are maximized and additional cash becomes available.

Conversely, TFSAs will work out better if your tax rate (including the effect of RRSP withdrawals on income-tested benefits such as the Guaranteed Income Supplement or Old Age Security benefits) will be higher upon ultimate withdrawal than it was when you contributed.

Of course, the numbers don’t always tell the full story since TFSAs are somewhat more flexible in that TFSA withdrawals can always be re-contributed in a future year, while RRSP withdrawals cannot (unless you have unused contribution room.)

Finally, if you’re currently making accelerated payments on your low-interest-rate mortgage, consider whether making RRSP or TFSA contributions might be a better use of your extra cash. RRSP/TFSA contributions may be a better option than paying down debt when your expected long-term rate of return on RRSP/TFSA investments is higher than the interest rate on your debt.