Should you put your money in an RRSP or a TFSA?

By Paul Russell,

When deciding whether to save in an RRSP or a TFSA, the choice is basically to pay the tax now, or pay it later. But there’s more to consider.

Here’s something we’d all welcome — you unexpectedly receive a $1,000 work bonus and want to invest it for the future. You have a personal tax-free savings account(TFSA) and a registered retirement savings plan (RRSP) at work. The $1,000 question is: Which account do you invest it in?

While the question is simple, arriving at the right answer for your situation can take a little thinking. Here’s overview of what would happen under a couple of different scenarios, assuming you are 35 years old, your investment generates a 5% annual investment return, and you’re in a 30% tax bracket during your career.

If you invest the $1,000 into your group RRSP at work, you can contribute the full $1,000 pre-tax. That’s because RRSP contributions are tax-deductible and you can get this tax deduction up front when contributing to a plan such as a group RRSP. (If you want to invest in an RRSP outside of a group plan, you would pay the 30% tax, invest the remaining $700 and top it back up to $1,000 with the tax refund you will receive.)

If you choose to invest in a TFSA, the actual amount you’ll have to invest is $700 ($1,000 less 30% income tax), so this would be the starting amount in your TFSA account.

Scenario 1: You make a mid-career withdrawal

As much as you were hoping to save your contribution for retirement, financial pressures require you to withdraw all of your savings at age 50. Per the chart below:

  • Your $1,000 RRSP contribution has grown to $2,079. But because all withdrawals from an RRSP are taxable, and you are in a 30% tax bracket, you are left with $1,455.53 after your withdrawal.
  • Your $700 TFSA contribution has grown to almost exactly the same amount, $1,455, and you can withdraw the entire amount tax free.

While what you have in your pocket is virtually identical in either case, the one advantage to a TFSA withdrawal is that you can recontribute the full amount any time starting with the next calendar year – and there is no loss of contribution room.

With an RRSP, you don’t get your contribution room back when you make a withdrawal. If you want to recontribute in the future, you’ll need to use unused RRSP contribution room.

Scenario 2: You make a withdrawal in retirement at age 65

If you save and invest your initial contribution until retirement, here’s what you will have when you withdraw the full amount at age 65. Per the chart below:

  • Your $1,000 RRSP contribution has grown to $4,322. If you’re in a lower tax bracket in retirement due to a lower income (say, 20%), you are left with $3,457.60 after your withdrawal. If you are in the same 30% tax bracket, you’ll receive $3,025. However, if you are in a higher tax bracket (say, 40%, perhaps because you sold your home and the proceeds of the sale have generated investment income, or you’ve inherited money that has generated income), you’ll only be left with $2,593.20.
  • Your $700 TFSA contribution has grown to $3,025, and you can withdraw the entire amount tax free.

TFSA vs RRSP chart

In the end, the pros and cons of a TFSA versus RRSP contribution may depend on whether your tax bracket in retirement is lower or higher than it was during your career when you made the initial contribution.

Another factor to consider is that because TFSA withdrawals are not considered taxable income, they do not affect your eligibility for income-linked government benefits like Old Age Security. For example, in 2015, if someone age 65 has income over $73,000, some of their Old Age Security benefit will be clawed back by the government, and the benefit will completely disappear at the $117,000 annual income level.

Many people use both RRSPs and TFSAs to save. But if you’re trying to decide which account to invest in when some extra money comes your way, consider the tax bracket you expect to be in when you hope to make your withdrawal. You should also consider whether you will use key TFSA benefits such as being able to recontribute withdrawals, and not having withdrawals count as taxable income for government benefit purposes.