Still not sure about RRSP vs. TFSA? Here’s how to use both

One of the biggest benefits of registered plans in Canada is the tax-deferral opportunity on the compound growth inside the plans. In other words, registered plans generally allow investors to avoid the periodic tax on investment income generated; non-registered plans, in contrast, expose investors to annual taxation of income distributions. Without the annual “tax-drag,” investments in registered plans can grow faster than investments in non-registered plans. Given that, which registered plan is best to use? Here are key factors to consider when deciding whether to invest in a Registered Retirement Savings Plan (RRSP) or a Tax-Free Savings Account (TFSA).

RRSP contributions are deductible against income, and RRSP redemptions are 100% taxable as income. TFSA contributions are made with after-tax money, and TFSA withdrawals are tax-free. Funds grow inside both plans on a tax-deferred basis. RRSPs and TFSAs are, in fact, designed to be tax neutral, assuming a constant marginal tax rate (MTR). When an investor has a constant MTR throughout his or her working and retirement years, there should be no difference between an RRSP and a TFSA in net after-tax income. The following table provides an example: 

That said, there remains an opportunity for tax arbitrage, quantified as the difference between the individual’s MTR when contributions are made versus the individual’s MTR when the funds are withdrawn. When the MTR is lower in contributing years and higher in withdrawal years, a TFSA is the better choice. When the MTR is higher in contributing years and lower in redemption years, an RRSP provides a greater tax advantage. The following table illustrates this concept.

It is possible to coordinate the use of an RRSP and TFSA strategically to maximize the absolute tax savings in a long-term wealth plan. The MTR tends to be lower for someone earning entry-level income in the early stages of a career, which favours the use of a TFSA over an RRSP.

As that individual advances in a career, increased earnings give rise to a higher MTR that may shift the preferred investment vehicle from a TFSA to an RRSP. In fact, this may be a good opportunity to “re-locate” existing TFSA savings into the RRSP to maximize the arbitrage opportunity. Of course, where savings permit new contributions, they should be directed to the RRSP.

In retirement, the shift to a lower MTR may make it advantageous to redirect withdrawals from an RRSP or a Registered Retirement Income Fund (RRIF) into a TFSA. At the same time, it may make sense to continue contributing after-tax earnings to a TFSA, as the individual will likely continue to remain at a lower overall MTR.

When considering MTR in retirement years, take into account any “mandatory” taxable income, such as Canada Pension Plan/Quebec Pension Plan (CPP/QPP) income, Old Age Security (OAS) income and any other pension income; the aggregate of these income sources establishes an individual’s minimum level of taxable income, which in turn determines the individual’s lowest MTR. Keep in mind that another advantage TFSAs have over RRSPs is that TFSA withdrawals generally do not affect income-tested retirement benefits.

As you can see, there is no “one-size-fits-all” solution when it comes to financial planning. A dynamic approach to optimize a wealth plan involves reviewing financial plans regularly and making necessary adjustments along the way.