RRSP vs. TFSA: a classic apples and oranges comparison

Much ink has been spilled about which is the better savings option for clients’ hard-earned money: the RRSP or the TFSA. And yet, there’s still no consensus on which is better. Perhaps this is because comparing the RRSP to the TFSA is like comparing apples and oranges.

Why the RRSP was created

The RRSP was created in 1957 to provide Canadians with a private savings plan for future retirement income. For those who were not members of employer-sponsored pension plans, it was an opportunity to set aside current income for future retirement income with similar tax advantages to pension plans.

It may help to view the RRSP as an income-deferral vehicle: you defer spending income today (up to 18% of your annual earned income to a maximum of $26,500), invest it within your RRSP and eventually (i.e. in retirement) withdraw a regular future income.

The benefits of doing so include no tax on the income that is contributed to your RRSP today and no tax on the investment income earned on your money while in an RRSP. The associated cost is that withdrawals from the account are taxed as income. In other words, income in and income out.

Why the TFSA was created

The TFSA was formally introduced in the 2008 federal budget with a clear focus on savings, and not income replacement. The point of the TFSA is to set aside current income, taxed today, for a future need in exchange for tax-free earnings and withdrawals.

In this context it may seem that the RRSP and TFSA are very different yet complementary options. So why all the comparisons? Perhaps budget 2008 started the fire with this distinction: “An RRSP is primarily intended for retirement. The TFSA is like an RRSP for everything else in your life.”

As a savings vehicle, the better comparison for the TFSA is a non-registered account, where all investment earnings and realized capital gains are subject to tax in the year they are earned. The TFSA compares very favourably. Annual contribution limits ($6,000 for 2019) restrict how much after-tax income can be set aside, but investments grow tax-free in exchange.

Does each option meet its intended need?

For a quick evaluation, it helps to recap some of the existing analysis comparing an individual’s tax rates at the time of contribution to either account, and their tax rate upon withdrawal. Holding time horizon and rate of return constant, and assuming pre-tax contributions for RRSPs and after-tax contributions for TFSAs, we find the following:

When an individual’s tax rate at contribution time is higher than when money is withdrawn, the RRSP generates a higher end value, net of all costs.
When an individual’s tax rate at contribution time is lower than when money is withdrawn, the TFSA generates a higher end value, net of all costs.
When an individual’s tax rate at contribution time is the same as when money is withdrawn, the end values for both the RRSP and TFSA will be the same, net of all costs.

Remember, the RRSP was created to provide a future income in retirement. Further, if future tax rates are lower than current rates, the RRSP provides a greater benefit than a TFSA. Are incomes generally higher when working and contributing to RRSPs than in retirement? The answer to this question may vary by client. However, if your client anticipates being in a lower tax bracket in retirement, then the RRSP seems well suited to accomplish its mission.

What if your client has a savings goal where the time horizon does not match the projected retirement age? What if their future tax rates are expected to be higher than their current tax rate? This is where the versatility of the TFSA is valuable. Clients can save for any reason, for any length of time, and withdraw tax-free. This is exactly what the TFSA was designed for.

So, what do I do?

Well, that depends on a client’s goal. Are they looking to set aside money for a retirement income or are they looking to save for the future (retirement or any other reason)? Do they need the ability to withdraw tax-free or would the taxation of withdrawals be a good incentive to keep their money invested? Do they receive income-tested benefits that would be reduced or eliminated if their income increased?

The answers to such questions should help clarify how to allocate clients’ money between RRSPs and TFSAs. Just remember, it’s not a choice between a good and bad option. Rather, it’s a decision about which is more suitable to a given situation. And the options today are better than they have ever been.