RRSP vs TFSA – A Matter of Timing

Should I contribute to my TFSA or RRSP? This is a common question when it comes to saving for retirement. It isn’t always financially possible to maximize the annual contribution to both, so many people often need to prioritize and invest in the registered savings account that makes the most sense for them.

In order to determine which option makes the most sense for you, it’s important to first understand the differences between them.

The differences between RRSP and TFSA accounts

RRSP TFSA
Funding contributions* RRSP contributions are made with pre-tax dollars TFSA contributions are made with after-tax dollars
Deductibility of contributions Contributions are tax deductible in the year they are made – or can be carried forward to another tax year Contributions are not tax deductible
Contribution limits Contribution limit is based on your earned income from the prior tax year – up to an annual maximum. Contribution room can be carried forward Contribution limit is predetermined each year. Contribution room can be carried forward

 

Investment income Investments grow tax-free Investments grow tax-free
Withdrawals Withdrawals are taxed.           No impact on contribution room Withdrawals are tax-free. Contribution room equal to the withdrawal is added back the following calendar year
Age limits Contributions can be made up to December 31 of the year you turn 71 No age limit

*Note: you need earned income (salary, self-employment income, etc.) to contribute to an RRSP. If you are an owner-manager of a corporation and remunerate yourself exclusively with dividends, you will not generate RRSP contribution room.

A primary difference between these two accounts is the timing of taxation:

  • An RRSP provides a tax deferral. This is advantageous if your marginal tax rate will be lower in retirement.
  • TFSAs permit tax-free growth of your investments. This option is most advantageous if your marginal tax rate will be higher when you withdraw the money.
  • If you expect your marginal tax rate to be the same at the time of contribution and withdrawal, then both options will yield a similar result.

Here is a simplified scenario to demonstrate this:

Higher Tax Rate at Contribution

RRSP TFSA
Pre-tax income $1,000 $1,000
Tax (53%) NA 530
Net contribution 1,000 470
Value in 20 years (6% per annum) 3,207 1,507
Tax on withdrawal (40%) 1,283 NA
Net withdrawal 1,924 1,507

Higher Tax Rate at Withdrawal

RRSP TFSA
Pre-tax income $1,000 $1,000
Tax (53%) NA 400
Net contribution 1,000 600
Value in 20 years (6% per annum) 3,207 1,924
Tax on withdrawal (40%) 1,700 NA
Net withdrawal 1,507 1,924

Same Tax Rate at Contribution and Withdrawal

RRSP TFSA
Pre-tax income $1,000 $1,000
Tax (53%) NA 400
Net contribution 1,000 600
Value in 20 years (6% per annum) 3,207 1,924
Tax on withdrawal (40%) 1,283 NA
Net withdrawal 1,924 1,924

Taxpayers generally earn a lower income in retirement, so one would expect most people to fit within the first scenario. In any event, the timing of taxation is an important thing to consider when you are evaluating whether to invest in an RRSP or TFSA.

March 1, 2019 is the deadline for contributing to an RRSP for the 2018 taxation year.  The tax professionals at S+C Partners would be happy to help you review your options and prepare for the upcoming tax season.