After reading this in-depth and well written analysis by David Chilton (AKA The Wealthy Barber) I was inspired to do some in-depth analysis of TFSA vs RRSP on my own.
Being a software developer, one outcome was WealthBar’s ultimate TFSA vs RRSP calculator. Another, is that I now know more than I ever wanted to about how RRSPs and TFSAs work. Here goes.
RRSPs vs TFSAs. Which one is the right option for you?
The short answer to the TFSA vs RRSP questions is that it depends. That said, saving for your retirement income using your RRSP will beat saving in a TFSA for the most part and for most people.
“Okay,” you say. “But what’s with the emphasis on for retirement?”
First, let’s review how RRSPs work. While we initially get a tax break on RRSP deposits, we will eventually have to pay income tax on our RRSP withdrawals.
A few other things are considered income during our retirement. That includes money we receive from the government like Canadian Pension Plan (CPP) payments and Old-Age Security (OAS).
Add to that, any income we might receive on the side. Rental property. Money from selling curios on Etsy. Any of these things are considered income. So our taxable retirement income looks something like:
RRSP + CPP + OAS + Etsy + other = Taxable Retirement Income
Now on the other hand, ordinary (non-registered) savings and TFSA savings are not considered income. That’s because we paid income tax on that money when we earned it. We also paid any taxes owed on growth (the money our money makes when it’s invested well).
The TFSA has the additional benefit of making all the growth tax-free as well.
So, why is the RRSP still better when we’ll eventually have to pay tax on it all in the end? Two reasons:
- When you save money in your RRSP, your tax savings (or tax refund) is calculated at the marginal tax rate. This is the highest tax rate you pay, but when you withdraw you can consider your income tax in retirement as an average rate.
- In the period when you are building up your savings, you are likely to have a higher income (in today’s dollars) than when you retire. Typically, retirement income needs are less than 80 percent of pre-retirement income.
Consider that before retirement you must set aside some income to save for retirement.
After you retire, you don’t. Also your mortgage may be paid off.
The RRSP will win as long as your marginal tax rate when you’re saving is likely to be higher than your average tax rate when you withdraw the funds. As we said earlier the RRSP lets you defer paying tax until retirement.
Your tax refund from saving in your RRSP will be based on your highest (marginal) tax bracket(s). However, in retirement, all of your retirement savings are basically mixed together.
You don’t pick which $1000 of savings is being withdrawn. That’s why it is more accurate to think about the tax paid on these savings in the future using the average rate.
Maximize RRSP savings to win
Chances are that maximizing your RRSP savings first is still the way to go. (If you’re already doing that, then by all means put any additional savings in your TFSA.)
Of course being just a ‘simple’ financial matter, there’s no way it could be that simple. We should also consider other things that impact our income in retirement.
For instance, there’s the old-age security (OAS) clawback which starts to kick-in you when your after-tax income exceeds ~$70k. That works out to about $90k of before-tax retirement income.
Furthermore, couples can “income split”. So that’s equivalent to $186k total household retirement income before the clawback kicks in. $180k of retirement income might be equivalent to over $225k in pre-retirement income. That’s true if we’re operating on the assumption of 80% of pre-retirement income in retirement.
That’s not too shabby. In fact, it’s in the top 5% of Canadians by income. But, lets consider some other ways only saving using our RRSP might affect us.
Let’s say you’re at retirement age (or near it) and you’ve been diligent about saving for your whole life.
You also have this one dream: your very own 24′ sailboat and cruising the world in it.
This is a pretty big purchase. If you dip into your RRSP, it’s quite likely to put you waaaay over your normal income and tax rates for that year.
This is the perfect scenario for your TFSA. If you saved for your boat using your TFSA, you can dip into your TFSA savings without increasing your income at all.
Compare the TFSA and RRSP using the marginal tax rate on the additional money you would have needed to withdraw from your RRSP to pay for the boat.
Now I feel we can answer the original question more accurately. “When should I use my TFSA over my RRSP?”
1) When you are planning on saving for large purchases (either long or short term).
2) If your current income (and thus tax rate) is well below your expected future income.
3) You are planning to really “live it up” and significantly increase your lifestyle during part or all of your retirement.
Having some money in your TFSA can help you avoid taxes on large expenses during retirement. It can even help you avoid OAS clawback if you’re income level is high enough. Otherwise, the RRSP is still be best primary account for basic retirement income savings.