RRSP vs. TFSA

A little math gives a definitive answer in the RRSP vs. TFSA debate

A lot of talk and newspaper column inches get spent on the topic of Tax-Free Savings Accounts (TFSA).

In particular, there are lots of musings about whether TFSAs are better than Registered Retirement Savings Plans (RRSPs) for retirement savings.

Now, as it happens, you needn't rely on musings. It turns out that we can apply les mathématiques to the question, and get a pretty definitive answer. I'll do the math. You just relax, sip your coffee, and prepare yourself to be a good saver.

You'll recall how an RRSP works: Every year, you can contribute the lesser of 18 per cent of your earned income or that year's maximum (currently $20,000 for 2008, and $21,000 for 2009). If you don't maximize your contribution in any one year, the unused portion carries forward and gets added to your maximum for the subsequent year.

When you file your tax return, you get to deduct the amount you contribute to an RRSP from your income, thus saving the marginal taxes you'd have otherwise paid on your contribution amount. You won't pay any tax on the return you earn while your money remains in your RRSP, but when you take money out it will be added to your income in the year of withdrawal. That's a key characteristic: an RRSP gives you a tax deduction for contributions, but you'll pay tax when you take money out later.

A TFSA, on the other hand, allows you to contribute up to $5,000 per year regardless of income, starting in 2009. Any unused contribution amount can be carried forward to future years. You won't pay tax on any return you earn on the money in your TFSA. And although you won't get a tax deduction for the contributions you make, there is no tax payable when you take money out of a TFSA. In that way, it's the opposite of an RRSP. No deduction on the way in, no tax on the way out. It's beautifully simple.

So what's better for retirement savings? The question really boils down to determining when you'd rather avoid taxes - now, or in the future? It's always best to refer to the specifics of your own financial plan (you have one, right?), but most Canadians will spend their working lives in a higher average tax bracket than they'll have in retirement. That makes the structure of an RRSP (and for that matter, a registered pension plan, which works in exactly the same way) the best way for most Canadians to build a retirement nest egg.

Here's a few numbers so you can see what I mean. Let's say you make $45,000 a year. You don't have a pension plan, so if you want to avoid living under a bridge and eating cat food in retirement, you need to save a lot of money. Should you put $5,000 into a TFSA - or more than $7,000 in an RRSP?

That's the question, you see, because that's the apples-to-apples cost comparison between making contributions to either plan. It'll cost you $5,000 of your hard-earned money to put $5,000 into a TFSA. But if you save in an RRSP, the same amount of after-tax dough will buy you a much fatter contribution.

If you make $45,000 a year anywhere in Canada, you're in at least the 29 per cent tax bracket (that's in Nunavut - it's worse in every other province or territory). That means that you can make an RRSP contribution of somewhere between about $7,042 (Nunavut) and $8,112 (Quebec), and the tax savings you'll get will knock your total cost down to $5,000.

Let's assume that you live in Nunavut, since that will give our illustration the least amount of tax savings for the RRSP. Let's also assume that you would buy the same investments in either the TFSA or the RRSP, and that you earn an average return of six per cent (assuming higher returns would increase the relative performance of the RRSP). Finally, let's assume you'll be saving regularly for twenty years. Should your annual savings practice be to put $5,000 in a TFSA, or $7,042 in an RRSP?

Well, if you used the TFSA, those assumptions would mean you'd end up with almost $184,000, tax-free. On the other hand, if you chose the RRSP model, you'd have about $259,000. Yes, you'd still have to pay tax when you pulled money out of the plan. But you'd have more than 41 per cent more capital, and that covers a lot of tax in retirement.

Now, here's the thing about retiring from a job that averaged $45,000 a year: Currently, if you qualified for the maximum benefits, your monthly Canada Pension Plan payment at age 65 would be $908.75, and your monthly Old Age Security cheque would total $516.96. That totals a whopping $17,108.52 per year in government-sponsored pension income.

Do you hear what I'm saying? Most people shouldn't worry about their marginal tax bracket in retirement - they should focus on building the biggest retirement pot possible. A TFSA is perfect for your emergency savings, saving for future expenses, etc. But for people who don't have a registered pension plan, deductible contributions to an RRSP will continue to be the backbone of their retirement savings strategy.