Which should it be: RRSP or TFSA?

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It happens every year – you’ve just paid the last of your Christmas credit card bills and now RRSP ads are in your face everywhere you turn and, as if to compound the demands on your cash.

Now you have to consider whether or not to fit a Tax-free Savings Account (TFSA) into the mix.

With money trees hard to come by these days, choices have to be made. Which should it be: RRSP or TFSA?

The TFSA was introduced in the 2008 federal budget, which set a 2009 start date for this new savings vehicle.

In the supplementary information to this budget, the federal government included a table showing a comparison of $1,000 of pre-tax income invested in an RRSP versus a TFSA.

As is the case with financial modeling, various assumptions were made (rate of return, tax rate), but the key one made in the example calculation was that the investor would be in the same tax bracket when funds were either contributed to or withdrawn from the RRSP.

Using a personal tax rate of 40 per cent and a rate of return equal to 5.5 per cent, at the end of 20 years the $1,000 investment would provide net after-tax proceeds of $1,751 regardless whether the amount was invested in an RRSP or a TFSA.

In other words, a taxpayer happily paying income tax at the same rate throughout his or her life would be indifferent between the two choices.

In order for this tax-rate assumption to be valid, a person’s inflation-adjusted taxable income would have to stay more or less the same each and every year.

Furthermore, personal income tax rates would have to remain the same.

Now a person only has to work in the labour force for more than a year to know that tax rates rarely stay the same year-over-year. For example, back in 1996 B.C. had the highest personal tax rate in the country topping out at almost 54.2 per cent; today B.C.’s top personal tax rate is 43.7 per cent.

So what happens then when taxable incomes differ before and after retirement?

Now my crystal ball is as cloudy as the next person’s, so generalizations are the order of the day.

Probably the most common experience is a decline in taxable income after retirement.  If this drop in income causes a shift to a lower tax bracket, the RRSP is generally preferable because the tax saving resulting from the earlier RRSP contributions is greater than the tax to be paid on the RRSP withdrawals.

On the other hand, if your retirement income is expected to exceed your pre-retirement income (think inheritance, for example), shifting you to a higher tax bracket, then the TFSA comes out on top because the tax saving resulting from the earlier RRSP contributions is less than the tax to be paid on the RRSP withdrawals.

Both of these generalizations rely upon a shift in tax brackets pre and post-retirement but they also hold true if your income doesn’t change but tax rates do change.

If you keep income constant and tax rates are lower when you retire then the RRSP is the winner; if tax rates are higher when you retire, the TFSA wins the race.

If you’re the type of person who likes to fiddle, you may want to play around with some of the numerous RRSP vs. TFSA calculators available on the internet (e.g., taxtips.ca), but bear in mind that all of these calculators must necessarily rely upon assumptions that may or may not be correct down the road.

Finally, there are other factors that should also be considered in the RRSP vs. TFSA decision.  For example, withdrawals from an RRSP create income; TFSA withdrawals do not.

Many benefits are a function of income including Old Age Security, Guaranteed Income Supplement, the Age Credit and the medical expense credit to name a few. And this income effect is not only a factor for the older crowd. A young parent who chose an RRSP over a TFSA could find a future cash shortage necessitates an early withdrawal which could cause a reduction in their Child Tax Benefit.

Jim Maroney is a chartered accountant with Meyers Norris Penny in Maple Ridge.