Market Buzz - Allocating Capital Between Your RRSP and TFSA

With the start of 2013 now behind us and the RRSP contribution deadline date approaching (Feb 29th), many Canadians are looking at their portfolios and staring to form a plan for the New Year. One decision that has to be made around his time is the amount of capital to contribute to the Registered Retirement Savings Account (RRSP) and Tax Free Saving Account (TFSA). In a perfect world, the best decision would be to maximize contributions to both accounts. However, real world scenarios often include limited resources which require most investors to analyze the benefits of each account.

Before we move into our comparison, it is probably best to make sure everyone is up to speed on how each of these vehicles work. The RRSP is a tax deferred account. Essentially, any Canadian can contribute a maximum of either 18% of their annual income or $22,450 to their RRSP on an annual basis. The government then allows you write this contribution off against your taxable income for that year. So an investor that contributes $10,000 to their RRSP and has a marginal tax rate of 40% would be credited approximately $4,000 on that year’s tax refund ($10,000 x 40%). As long as your money remains in your RRSP, you can continue to generate returns on a tax deferred basis. We say tax deferred because any capital withdrawn from your RRSP will be added to your taxable income for that year.

The TFSA is what we refer to have a tax free account. Any Canadian, over the age of 18, is permitted to contribute a maximum of $5,500 in 2013 to their TFSA (contribution increased from $5,000 in 2012). The money can be put into a wide variety of eligible investments, including stocks, bonds, and in some cases, even private companies. Unlike the RRSP, an investor cannot use their TFSA contribution to reduce their taxable income for the year. However, any money contributed to the TFSA can continue to generate returns indefinitely, which are then completely tax free. Even when you withdraw your money from the TFSA you still don’t pay tax.

The best way to understand the two accounts is to use an example. Let’s take two investors, Mary and Sam. Each of these investors is in a marginal tax rate of 40%, and each wishes to contribute $10,000 in pre-tax income to a registered account (Mary to the RRSP and Sam to the TFSA). Because Mary is contributing to here RRSP, she can contribute the entire $10,000 and not have to worry about the tax (at least for now). Sam on the other hand, has to pay the taxman and is left with $6,000 ($10,000 x (1 – 40%)) to put in his TFSA. So Mary starts off with $10,000 and Sam starts off with $6,000. Over the next 15 years (assuming no additional contributions) both investors generate an average annual return of 6%, so at the end of the period, Mary’s RRSP is worth $23,965 and Sam’s TFSA is worth $14,379. It would appear at first sight that the RRSP won the battle of long-term returns; however, look at what happens when both Mary and Sam decide to withdraw the money from their accounts. Sam already paid his tax before he made the contribution and the returns accrue tax free. When he withdraws his money he receives the entire $14,379. Mary on the other hand did not pay tax on the initial contribution but is taxed on withdraw. Assuming that her marginal tax rate is still 40% she would receive net cash of $14,379 ($23,965 x (1 – 40%)). This happens to be exactly the same as what Sam received.

What this example is intended to illustrate is that the value of RRSPs relative to the TFSAs is primarily a function of the difference between your tax rate when you make the contribution and your tax rate when you withdraw the funds. If for example, Mary’s tax rate had declined to 30% at the time that she withdrew her money from her RRSP (assuming a lower tax rate in retirement), she would have be left with $16,775.50. Think of it this way...with the RRSP you pay the tax on withdraw whereas with the TFSA you pay the tax at contribution. If your tax rate is going to be lower at withdraw then at contribution, the RRSP is the best vehicle. If your tax rate is lower today (at contribution) then it will be when you withdraw the funds, the TFSA is the best vehicle. The RRSP is intended to be used for old age and one might think that your income (and likely tax rate) will be lower at retirement than in your prime earning years. This is not an unreasonable conclusion but it will not apply to all situations. If for example an individual were to be making low income in a particular year as a result of unemployment, underemployment, maternity leave, leave of absence, health issues, etc, then the tax rate could actually be higher in retirement making the TFSA the more suitable choice. There is also the possibility that funds may have to be withdrawn before retirement as a result of emergency or even business opportunity. While it is rarely advisable to withdraw funds from an RRSP before retirement, it does happen on occasion.

One factor that is rarely discussed but important to consider is how your RRSP or TFSA will impact your eligibility for senior benefits in retirement. Seniors earning annual income over a certain threshold will in fact not be eligible for some government sponsored benefits in retirement. Capital withdrawn from the RRSP will impact these benefits but investment returns and capital withdrawn from the TFSA will not.

Conclusion

Unfortunately there is no easy answer between the choice of RRSP or TFSA. The suitability of each vehicle depends primarily on the difference between the individual investor’s tax rates when they make the contribution compared to the tax rate when they withdraw the capital. If the tax rate is higher at contribution then the RRSP is likely the superior vehicle. If the tax rate is higher at withdraw then the TFSA is likely the superior vehicle. Of course, no one is able to say what our tax rate is going to be in the next 10, 15, or 20 years or how the government is going to change the rules applied to these two registered accounts. This makes it pretty much impossible to determine with certainty which account is the better option. Rather than stress too much about it, the most important thing is that individuals are saving money for retirement and making use of these tax advantaged accounts. Each individual investor can either choose one of the two accounts into which to make their annual contribution or they can split their total annual contribution equally (to the extent that contribution limits will allow) between the two options. Using either one is almost always better than not using them at all.