RRSP, TFSA, or both?: The truth is, it depends

Here we look at some considerations for how and when to use these two popular registration types.

You may be surprised to learn that there really is no “right” choice between an RRSP and a TFSA – there’s only the choice that’s right for you.

That’s why when coming up with a strategy to best meet your savings needs it’s so important to have a good understanding of how these two options actually work.

For starters, here’s an at-a-glance comparison:

Vehicle	How it works	What it’s good for
RRSP	The value of your contribution generates a deduction from taxable income. Any investment gains or income are sheltered from taxation – ideally until retirement when you can withdraw funds and pay tax at a lower rate because your income will (usually) be lower.	Paying for a long-term project, such as retirement when taxable income is expected to be lower than current.
TFSA	Unlike RRSPs, there are no tax-deferral advantages – you contribute after-tax dollars and can’t deduct them from reported income in the contribution year. That said, income and gains within, or withdrawals from, the TFSA aren’t subject to taxation, and withdrawing funds does not affect your contribution limit.	To support other sources of income in retirement or when you might not be ready to commit those funds to longer-term plans.

Up front: A bit of context

Before we take a closer look at these two options, here are a few quick points and caveats to keep in mind along the way:

TFSAs or RRSPs by themselves are registration types – not actual investments. For example, you can’t “buy an RRSP”, but you might buy a GIC or a mutual fund (investment) within an RRSP.
It’s important to be wary of one-size-fits-all advice. Wealth Management is so personal. You can have two individuals with very similar lives and financial situations, but the right strategy might be completely different for each of them.
What works for you this year might not work next year, so be flexible and adjust as you go. When trying to decide how to save, you should weigh all the factors that affect your financial health now – as well as those that could affect it in future.
Consider where you’re at today and where you think you’ll be in future. The decision to use a TFSA or an RRSP involves taking a look at current and future estimated tax brackets, length of time to commit and also the intended construction of a retirement portfolio.
Create a sound retirement plan. This will help ensure your decisions are rooted in logic vs what may just be popular out there in the market right now. You’ll also be in a better place to know what options you should be considering along the way to help you reach your goals, grow your money, and how and when to refresh your savings strategy if you need to.

An analogy: TFSAs and RRSPs are like parking garages

TFSAs and RRSPs both protect you from taxes – and they’re structured differently in how they do this. Robert Bradburn, an Assistant Vice President with CWB Wealth, has a great analogy for explaining the key differences between the two. And it involves…a parking garage.

TFSAs
“Think of a TFSA as a parking garage that shelters vehicles (investments) from the rain (tax),” says Bradburn. “If you park a vehicle outside of the garage, it’s going to get caught in the rain. Once you park your vehicle inside the garage, it is sheltered.” You can fit any type or number of vehicles inside the garage – from savings accounts to mutual funds – as long as their value when contributed to the TFSA doesn’t exceed the total contribution limit. And when you leave the garage, you will not be taxed.

RRSPs
Bradburn says that, from a tax-sheltering perspective, an RRSP can also be thought of as a parking garage. “That is, of course, in some universe where the parking attendant is so happy to welcome you to the garage that he actually gives you money at the booth – aka your tax-return for deducting your RRSP contributions,” he says. “Similar to a TFSA, while you’re parked in the garage your vehicle stays dry and sees no taxes. Unlike a TFSA, you’re also charged when you leave because you have to pay tax. That tax is the amount taken out of your RRSP multiplied by your personal tax rate. You want to make sure you pay less to get your money out than what you were given to put your money in. This money is viewed as regular income and, because the money is now deregistered, any future growth on it will also be taxed.”

Pro tip: Building a ‘personal pension’ with TFSAs
“Often times in Wealth Management we’ll see couples with $150K each in their TFSAs. Those could easily grow to a least $250K each before they’re needed for retirement. Investing $500K in something relatively safe and consistent like Canadian Financials & Utility Companies generating an average dividend of 5% would create $25,000 of non-taxable income each year without touching capital. Add that to Old Age Security, Canada Pension Plan, RRSP savings and any third party pensions, and it makes for a very sound retirement.” – Robert Bradburn, AVP, CWB Wealth

Two similar situations, two different strategies

Let’s take two hypothetical Canadians with the same income, who each have $10,000 to save this season. Assuming their contribution limits allow, you might think they should both put the money into their RRSPs and get a step closer to their retirement goals. Yet that might not be the right choice. For instance, perhaps one of our hypothetical Canadians believes their job is not secure. In that case, a TFSA might be more appropriate, because it would allow tax-free access to emergency funds. Alternatively, a contribution to the RRSP might generate a nice deduction during a high income year, and a withdrawal from it could be made in a low income year (if she were to lose her job for example). Our hypothetical Canadian would be able to capitalize on the difference between generating a deduction at a high income rate and being taxed at a lower rate on withdrawal. Further, maybe this same job-insecure person knows their company has a generous severance policy. They could choose to contribute to an RRSP because they are confident they won’t need an emergency reserve. Or perhaps they have a partner who has a secure job.

To help weigh the pros and cons, here are a few general circumstances where a TFSA contribution might be preferable to an RRSP.

A TFSA is a simple option to generate tax-free income in the future.
The benefit of an RRSP contribution is optimized when income is deducted from a high tax bracket and tax is then re-applied at a much lower rate. So, this might mean that Canadians in their peak earning years prioritize RRSP contributions over TFSA. In contrast, a young person might park savings in a TFSA and save their RRSP contribution room for a year when they have higher income, then transfer the funds to a RRSP as they move into a higher tax bracket.
A TFSA can also play another important role in retirement, because it can help retirees avoid income spikes when they need large sums of short-term cash. Take this example. Consider a retiree who lives in their own house and suddenly needs $50,000 for a renovation. If all their savings are in an RRSP, they would have to withdraw about $71,500 to get their $50,000 net of withholding taxes. That withdrawal would dramatically increase their taxable income for the year, which could mean Old Age Security benefits may be clawed back. They might also have to pay tax on the RRSP withdrawal beyond the withholding taxes. However, if you have money in a TFSA, you could withdraw the $50,000 – it’s not taxable income – and you have only earned your normal income for the year. And then in coming years, if you have surplus funds, you can return all or part of that money to the TFSA.

“Each situation is unique and there are multiple factors to consider,” says Bradburn, who adds it’s also important to consider what your sources of income will be in retirement. “For example, what is the tax bracket you fell in when you put investments into your RRSP versus your anticipated income when you take it out? What are the chances you will need to use that money prior to retirement? The rule is to be in a higher tax bracket when you contribute to an RRSP and a lower one when you withdraw.

“So…which one’s better? Or should you be using both? The answer really is: it depends.”

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