RRSP vs TFSA
RRSP vs TFSA
A Decade Old Debate
As the TFSA continues to grow up and embarks on its second decade of life, the debate over whether to use an RRSP vs TFSA rages on.
So which one should you use?
The short answer is: it depends. The long answer: well it also depends.
Obviously if you max out both accounts each year, the answer is simple. However, if you don’t, this guide will help determine which account to contribute to first.
The Main Difference Between an RRSP and a TFSA
You get a tax refund contributing to an RRSP and you pay tax on all the money that will eventually come out of the RRSP (or RRIF). Compared to the TFSA, contributions go in using after tax dollars (no tax refund) but when you take the money out you pay no tax on any withdrawals.
In both cases, all earned growth inside the accounts grow tax free.
Which Account Should You Contribute to First
There are the two factors to consider when choosing which account to contribute to first. Both need to be considered when making the decision of whether to contribute to an RRSP or TFSA.
Your current tax bracket.
Whether your retirement tax bracket is expected to be higher or lower than the current years income tax bracket.
To help understand your tax bracket better, here is a breakdown of what the federal and provincial tax bracket ranges look like in Ontario for 2020. If you are in a different province, you can click here to find out your 2020 tax bracket.
Federal Tax Rates 2020
Ontario Tax Rates 2020
5.05% up to $44,740
9.15% over $44,740 up to $89,482
11.16% over $89,482 up to $150,000
12.16% over $150,000 up to $220,000
13.16% all income over $220,000
15% up to $48,535
20.5% over $48,535 up to $97,069
26% over $97,069 up to $150,473
29% over $150,473 up to $214,368
33% all income over $214,368
Current Tax Bracket
As a general rule, if you are in the highest tax bracket, you would contribute to an RRSP first. Likewise if you are in the lowest tax bracket you should consider contributing to a TFSA first. This is simply due to the value of maximizing the tax refund for the highest tax bracket earners. Moreover, lowest tax bracket earners would benefit from maximizing the amount of after tax income to contribute to a TFSA.
However, this is only one of two factors to consider. As mentioned, both need to be used together to make the best decision.
Retirement Tax Bracket: Higher or Lower Than Today
The second consideration when deciding whether to contribute to an RRSP or TFSA is your future retirement tax bracket. This will be more difficult to come up with and will rely on your forecast of income and tax bracket in retirement. As a general rule, if your income tax bracket is going to be higher in retirement than today, you may be better off contributing to a TFSA. Likewise, if your retirement income tax bracket is going to be lower than today, you may be better off contributing to an RRSP.
If you find your income at the high or low end of the tax brackets, the decision might be a bit more black and white. However, you might find your tax brackets continually fall within the grey area. When we put the two scenarios together, they form the RRSP vs TFSA Matrix. This should help give you a better idea of which account to at least contribute to first.
Move with the arrows based on your current tax bracket and your expected retirement tax bracket in retirement, to find which quadrant you are in. The further away from the centre (grey area), the more obvious the choice.
RRSP vs TFSA Matrix
Tax Brackets in the Grey Area
The grey area does not have to be confusing or complicated. In fact it is the exact opposite. If you find yourself in the grey area, the benefits of choosing one over the other (RRSP vs TFSA) may not be significant enough to make the wrong decision. In other words, you may benefit from spreading out your contributions each year and contributing a bit to both.
Keep in mind, one benefits of the TFSA is you can withdraw the money at anytime tax free. Should you find your tax bracket at the high end of the range one year, you can always choose to take some of your investments from the TFSA and make an RRSP contribution in a the higher earned income year.
One Final Note
Life is unpredictable and will throw many curve balls your way. Even with the perfect plan, things will still change. The most important aspect of either an RRSP or TFSA is the ability to compound your money tax free for many decades. If the choice still seems confusing or overwhelming, don't forget what the main goal is: to build long term wealth. You are better off picking the wrong account from a tax perspective, than choosing to do nothing at all.
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