by Scott Ronalds

It’s that time of year. Cold days, long nights, holiday garland that’s overstayed its welcome, and the perennial question — RRSP or TFSA?

With the March 1 RRSP deadline approaching and a fresh $6,000 in TFSA contribution room available (for 2022), investors are wondering which tax-advantaged account they should be contributing to. The simple answer in many instances: both. Yet, this may not be practical for everyone, so let’s unpack the question and explore a common scenario.

Rules of thumb

First off, a few rules of thumb. These don’t apply to everyone, so take them with a grain of salt.

Purpose of the money: If you’re saving for retirement, the RRSP was designed for you (it’s in the name). But there’s a caveat — if you earn a low income (see below), the tax advantages of these plans are eroded. If you have a short- or medium-term goal in mind (new car, home purchase, travel, renovation), think TFSA.

Income: If you earn a good income, the RRSP is the way to go (again, if you’re saving for retirement). $50,000/year is typically considered the drawing line (more on this below). In other words, if you earn under $50K, the TFSA may be the better option.

Flexibility: If you want/need access to your money without penalty, TFSAs offer the most flexibility.

Revisiting the virtues of the RRSP

The benefits of RRSPs have come into question in recent years, as the advantages of TFSAs have been widely touted and there are still some misconceptions around the tax benefits of the Registered Retirement Savings Plan.

Make no mistake, the RRSP is still relevant. Indeed, it’s a fantastic retirement tool for those who earn a solid income and don’t have a company pension plan (which are rare these days).

As a refresher, any contributions that you make to an RRSP have an accompanying tax benefit: the amount you contribute is deducted from your taxable income. Let’s say you make $100,000 and contribute $10,000 to your RRSP. Your taxable income is reduced to $90,000, so in essence, your tax savings represent the amount you would have paid (in tax) on your last $10,000 in income. If you live in B.C., this represents a savings of about $3,260, and in Ontario, it’s over $3,700. If your income is higher, the tax savings are even greater. Check out our RRSP Tax Savings Calculator to determine your estimated savings.

If your income is lower, your marginal tax rate will be too, and the corresponding tax savings resulting from an RRSP contribution may be minimal. As previously noted, $50,000 is considered a guidepost, as this is roughly where marginal tax rates start to escalate. If you earn less, the TFSA may be a better retirement savings vehicle.

I’d argue, though, that there’s an additional, less tangible, benefit of RRSPs that should be considered: these accounts encourage ‘forced’ savings. Because premature redemptions are penalized via withholding taxes, RRSP holders are incentivized to leave their accounts alone and let their investments compound over time rather than tapping into them for discretionary or non-emergency purchases.

Once you start drawing from your RRSP (i.e., when it’s converted to a RRIF), you must include any withdrawals in your income. Because you’re retired at this point (or may be winding down your career), your income and tax rate will likely be lower. Herein lies the key advantage of the RRSP — you are ultimately paying less tax on your hard-earned retirement money. Plus, all investment growth is tax sheltered until withdrawn.

If you expect that your income and tax rate in retirement will not be lower than in your working years, an RRSP may not be suitable for you. This is also why it may not make sense to contribute to an RRSP if you have a modest income.

One last consideration: if your RRSP grows to a substantial size (e.g., over $2 million), it may inadvertently lead to tax consequences in retirement when it comes time for withdrawals, such as OAS clawbacks and a higher marginal tax rate. If your account nears the multi-million dollar mark, it may be advisable to speak to a financial planner about halting further contributions.

Those fabulous Tax-Free Savings Accounts

Hard to believe, but the TFSA is marking its 14th anniversary this year. These accounts are a rare gift from the taxman in that all investment growth is tax-free and you never have to include any redemptions in your income.

They also offer great flexibility as you can redeem money without penalty, they have no annual contribution deadlines and no expiry dates (i.e., they don’t have to be converted to another type of account), and you can re-contribute any money withdrawn (although it must occur in the subsequent calendar year).

Further, if you don’t use your contribution room in any given year, it carries over indefinitely. TFSAs do not, however, offer an up-front tax advantage on contributions like RRSPs.

The only problem with TFSAs is that they’re misnamed. They should be called Tax-Free Investment Accounts. We speak to too many Canadians who aren’t aware they can hold stocks, bonds, mutual funds, ETFs, and other growth investments in them. The tax-free nature of these accounts largely goes to waste if investors with a long time horizon fill them with ultra-low yielding GICs or savings products. But that’s another story.

TFSAs are a great investment vehicle for a number of goals, including:

• Investing for retirement, in complement with your RRSP
  
• Saving for a big purchase or event
  
• A place to re-invest a portion of your RRIF payments
  
• Saving for your child or grandchild’s education, in complement with an RESP
  
• Gifting to your adult children (by funding an account in their name)

A word of caution though: be sure not to overcontribute to a TFSA, as the penalties are harsh. The lifetime cumulative contribution room currently sits at $81,500 (for those who meet all eligibility and age requirements), and this year’s limit is $6,000 as noted. If you’re not sure what your contribution room is, you can confirm with CRA (Canada Revenue Agency).

As mentioned at the outset, if you have the means, you should consider contributing to both an RRSP and TFSA. If it’s one over the other, you need to consider the purpose of the money and your time horizon. Lastly, your income may be the deciding factor. Our TFSA versus RRSP Calculator can help you in this respect.

Sara and Jim’s scenario

Lori Norman, one of our Investor Specialists, and I recently spoke with two prospects who provide an interesting example of the RRSP vs. TFSA question.

Sara and Jim (names changed for this article) are mid-life professionals wondering how they should be allocating their investments. Sara currently has most of her savings in RRSPs (a group plan at work and an account at the bank) and doesn’t have a TFSA. Jim has a smaller RRSP and a modest TFSA. Together, they have about $300,000 in RRSPs and $35,000 in the TFSA. They both make good incomes, coming in at about $200,000 combined, and are aiming to invest a total of $1,000/month.

The couple’s key goals are two-fold: (1) save and invest for retirement (20-25 years away); and (2) save for a vacation home (10-12 years away).

Given their healthy income levels, it makes sense to continue contributing to their RRSPs. We suggested that the emphasis should be on Jim’s account for now, however, considering its smaller balance. For the second home goal, they should be using TFSAs (Sara needs to open one).

We ran some numbers for them using our Savings Growth Calculator to illustrate a few scenarios. For example, if they invest $600/month in their RRSPs for 20 more years, the accounts will grow to $1.27 million (assuming an average return of 6% per year). If they can contribute for 25 years, the sum will exceed $1.75 million.

With the other $400/month going towards their TFSAs, the accounts are projected to grow to $120,000 over 10 years (we used a more conservative 5% average return here, as the time horizon is shorter and the investment mix therefore more conservative). If they increase the time horizon to 15 years, the pool is expected to grow to over $180,000 ($200,000 if they earn 6%).

Sara and Jim need to decide if these amounts are sufficient, and if not, which goals they want to prioritize (and tweak their contributions accordingly). It’s clear, though, that both RRSPs and TFSAs will play an important role in their plan.

Final thoughts

Your unique financial situation and investment goals will dictate which account you should focus on. As well, your investment strategies may well differ between the two accounts. For example, you might view your TFSA as a high risk, high reward account given that you never have to pay tax on any gains (I’m in this camp). Your RRSP, on the other hand, may be invested more conservatively, as you don’t want to jeopardize your future standard of living.

You’re not alone if you’re wrestling with the RRSP vs. TFSA question. Our Planning Calculators can help in your decision making. Or if you’d like to flesh out the topic in more depth, you can book a call or video meeting with one of our Investor Specialists. They’re acronym experts.