What would Elmer Fudd Do? (RRSP vs TFSA)

National Post

2009-01-31

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The raging debate among advisors this year brings back vivid memories of watching early-morning Loony Tunes cartoons, where the perennial question was: Is it rabbit season or duck season?

The question in 2009 is: RRSP season or TFSA season?

With limited funds, which one do you choose -- the TFSA or RRSP?

Given this past week's federal budget, perhaps a third, better choice is forgoing both in favour of that home renovation, which could generate up to $1,350 of tax savings thanks to the new Home Renovation Tax Credit.

If you are planning to save the money instead of spend it, choosing between the RRSP and the TFSA essentially comes down to comparative tax rates.

The two plans are meant to be tax-neutral, as the first column in the chart demonstrates.

It compares the after-tax accumulation over 20 years of $5,000 of income earned by an individual that is put into either a TFSA or an RRSP.

In the TFSA scenario, the $5,000 is taxed upfront (when earned) at the individual's marginal tax rate (assumed to be 40%) and the after-tax amount of $3,000 is invested in the TFSA.

Since the earnings and growth inside the TFSA are not taxed during the accumulation phase, nor are they taxed upon ultimate withdrawal, the net after-tax value after 20 years, assuming a 3% growth rate, is $5,418.

Now, assume you earn $5,000 of income but you don't have to pay tax on it currently because you put it into your RRSP and claim a deduction for it.

Thus, the full $5,000 is invested, grows to $9,031 and is ultimately taxed in 20 years' time at 40%, netting you exactly the same amount after-tax, 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.

As the second column shows, RRSPs make more sense when the tax rate upon withdrawal is expected to be lower than the tax rate upon original contribution.

Conversely, the third column demonstrates that TFSAs will work out better if your tax rate (including the effect of RRSP withdrawals on income-tested benefits such as GIS or OAS) will be higher upon ultimate withdrawal than it was when you contributed.

Of course, the numbers don't always tell the full story since TFSA withdrawals can be re-contributed in a future year, while RRSP withdrawals cannot.