When thinking about age old questions there are a few that come to mind: chicken or egg? Toronto Maple Leafs or Montreal Canadiens? In the financial space, the equivalent question has to be whether you should contribute to RRSPs or TFSAs.
The short answer is: it depends. Every situation is different but by answering the questions below you will have a better sense of what is better in your situation.
Before we go further a quick recap on the differences between RRSPs and TFSAs.
RRSPs are funded with pre-tax dollars i.e. your contributions reduce taxable income. Funds grow in RRSPs tax free. At age 72 the CRA requires you convert your RRSP into a Registered Retirement Income Fund (RRIF). Once the RRSP becomes a RRIF, whether you need the funds or not, you must withdraw a minimum predetermined amount each year. This withdrawal counts as income and is taxed just as if you were earning a salary.
TFSAs are funded with after tax dollars. Like the RRSP, funds grow in the TFSA tax free. Different from the RRSP, funds can be withdrawn from the TFSA at the holder’s discretion and without any tax imposed.
To find out what moves the needle in allocating funds to either RRSPs or TFSAs answer the following:
How much did you make last year?
The RRSP contribution limit for 2016 is set at 18% of your last year’s income up to a maximum of $25,370. If you made $50,000 in 2015, you can contribute up to $9,000 ($50,000 *18%) to your RRSP and get a tax refund of about $2,500. If you made $100,000 in 2015, you can contribute $18,000 ($100,000 * 18%) to your RRSP and get a tax refund of about $7,400. You will note that a doubling of your income results in almost three times the tax refund for the same percentage (18%) contribution. This is due to Canada’s graduated tax system whereby as you earn more income, you reach higher tax brackets and pay increasingly higher percentages of tax. In other words, the more you make the higher average tax rate you will pay.
Looking at last year’s income, the more you made, the higher your average tax rate, the larger your tax refund, the more beneficial contributing to your RRSP can be.
How old are you?
RRSPs and TFSAs are effective investment vehicles due in large part to the ability of the investments grow tax free (i.e. earn interest, dividends and capital gains without causing an annual tax bill). Avoiding annual tax allows for faster compounding of assets. Compounding over a long enough period can result in substantial growth as returns are generated on returns. However, the benefits of compounding are not experienced overnight but rather, like an exponential equation, take years to become material. If you are planning to retire at some point within the next decade you may be forced to withdraw contributions from your RRSP before benefiting from compounding. In this case allocating to TFSAs would be preferable as there are no demands on the timing and quantum of when funds must be withdrawn.
If you are nearing retirement, your investments can compound tax free for a greater number of years with a TFSA.
What is the balance of your RRSP right now?
It is worthwhile to examine how much is invested in your RRSP to date. Here’s why: if you are in your mid 40s (say 45) and have accumulated a balance of $500,000 in your RRSP, at a 7% return for the next 27 years, until the RRSP converts to a RRIF at age 72, your account could grow to over $3.1M. Based on CRA’s prescribed withdrawal amounts, at age 72 you must withdraw 5% of the balance or about $155k as income. Depending on fiscal policy at the time, this withdrawal could be subject to the highest tax rate. Therefore, taking into consideration your age and account balance, at a certain point additional contributions to your RRSP will benefit CRA more than you or your family.
If you are on track to have an RRIF balance of much greater than $3M at age 72, you are better off contributing to a TFSA.
Have you set up a spousal RRSP?
One of the last options for ‘income splitting’ is the Spousal RRSP. Under this type of plan, the higher earning spouse can use their personal RRSP contribution limit to fund an account in their spouse’s name. The idea is that when the RRSP converts into a RRIF, the spouse will have lower annual income and be able to withdraw funds at a lower average tax rate. As an example if Jill is an emergency room doctor and her husband Jack is a paramedic, it’s reasonable that Jack will have lower income over his career. By Jill contributing to a Spousal RRSP, she will still receive the tax benefits but the funds will be in Jack’s name. When they both retire, if Jack’s combined RRSP and Spousal RRSP balance is lower than Jill’s, he will pay less tax on withdrawals than if Jill had contributed the funds to her RRSP account all along.
Examine the balances of your RRSPs and if one spouse has a larger balance, divert funds to the smaller balance accounts.
How much will you make in retirement?
If in retirement earnings are still expected to be in the higher tax brackets, RRSPs will be less useful. This is because RRSPs are intended to create high tax deductions in your high earning years and deferred income at a lower tax rate in your lower earning retirement years. For some folks, often business owners, their income will remain high in retirement thereby reducing the effectiveness of RRSP income deferral.
If you will still earn substantial income during your retirement, your RRIF withdrawals will be subject to high tax rates so allocate to your TFSA.
What will your cash flow needs be?
For those planning to retire before 72, rather than prematurely converting the RRSPs to a RRIF, TFSAs can be used as a handy vehicle to supplement income needs and allow for continued compounding in the RRSP account. Since there are no annual rules imposed on TFSA withdrawals it can act as an on demand source for cash. Further to the extent there are extra funds left after a RRIF payments, these monies can be invested in TFSAs.
If you are bridging the gap between retirement and age 72, avoid prematurely paying tax on your RRIF and draw down your TFSA.
Overall, it’s often not black and white whether you should allocate to RRSPs or TFSAs. Consideration should be given to among other things, your age, current account balances, retirement age, and income levels in retirement. The best way to determine where to allocate funds is to speak with an advisor that can go through a scenario analysis and suggest the optimal path forward.