How your tax bracket decides whether a TFSA or RRSP contribution is best

I was a bit surprised to learn recently that TFSAs had just ‘turned ten’.  It seems like just yesterday that I was answering questions from the media about how these newfangled government-sponsored programs might change the landscape for investing in general and retirement planning in particular. Former Minister of Finance Jim Flaherty sang the praises of the new program a decade ago by stressing the ability to avoid paying tax when using TFSAs. Many pundits weighted in expressing regret that the third word was “savings” and not “investing”.  In actuality, the program is used primarily as a tax-free investing account, so perhaps TFIA would have been a better moniker.

Irrespective of what people thought TFSAs might mean when they were first introduced, there is no denying that they have been wildly popular and broadly embraced by Canadians of all walks of life. Now that RRSP season is upon us (the deadline for 2018 is March 1, 2019), many people wonder if they should contribute to their RRSP or their TFSA since most people don’t have enough money to maximize both options. If you can only do one of the other, which makes more sense? Assuming we’re talking about retirement money, the answer depends on two things: your marginal tax rate in 2018 and your marginal tax rates in your retirement years. Let’s begin with the federal tax brackets.  They are:

Income range Marginal tax rate
On the first $47,630  15.0%
Over $47,630 up to $95,259 20.50%
Over $95,259 up to $147,667 26.00%
Over $147,667 up to $210,371   29.0%
Over $210,371 33.00%

The large majority of Canadians are in either the first or second bracket (i.e., most Canadians make less than $95,000 a year).  What follows is an exercise that works in moving between all brackets, but, for the sake of simplicity, will be illustrated in moving between the second bracket (between $47,630 and $95,259) and the first (under $47,630).

From an after-tax perspective, most people would likely be indifferent between an RRSP and a TFSA.  That’s because most people are in the same tax bracket when working and when retired. When comparing RRSPs and TFSAs, remember that the former gets you a deduction on the way in (i.e., when contributing), but is taxable on the way out (i.e., when making a withdrawal). As a result, the tax consequences are a bit like the old Fram auto filter commercials—“you can pay me now, or you can pay me later”. Perhaps I’m dating myself.

Financial planners often tell their clients that they will likely have a retirement income that is less than two-thirds of what their working income was.  For purposes of our example, let’s say we’re talking about someone who made $60,000 a year in 2018 and took a somewhat standard approach of saving 10% of their income for retirement. Putting $6,000 aside is a good thing to do and choosing one account over another is still far more fruitful than choosing not to save anything (perhaps on the flimsy pretence that you can’t decide which government-sponsored program to use).

If the person in the example was to earn more than $47,630 in retirement, that person should be indifferent between an RRSP and a TFSA, because the tax-deferred compounding in the former (deduction on the way in, tax on the way out) would be exactly equal to the tax-deferred compounding in the latter (no deduction on the way in; no tax on the way out).

Most people earn less in retirement while maintaining a similar standard of living due to having put their children through school, paid off the mortgage and so forth.  As a result, it is not uncommon for someone who was earning $60,0000 a year while working to earn less than $40,000 a year in retirement.  Such a person would be in a position to benefit from ‘tax bracket arbitrage’ by using an RRSP.  Such a person could get a deduction of 20.5% ($1,230) now while paying tax on a $6,000 withdrawal ($900) years later.

Remember that there are provincial tax brackets, too, but to be as simple and generic as possible, we’re just looking at federal rates here. While many people have no strong opinion when choosing between RRSPs and TFSAs, there is a clear advantage to RRSPs for those people who have more than modest incomes that are likely to be a fair bit lower in retirement. For most people earning over $47,0000 a year, therefore, RRSPs are likely to be the better option.

John J. De Goey, CIM, CFP, FELLOW OF FPSC™ (the author) is a registrant with Wellington-Altus Private Wealth Inc. (WAPW). WAPW is a member of the Canadian Investor Protection Fund (CIPF) and the Investment Industry Regulatory Organization of Canada (IIROC). The opinions expressed herein are those of the author alone and do not necessarily reflect those of WAPW, CIPF or IIROC. Investors should seek professional financial advice regarding the appropriateness of investing in any investment strategy or security and no financial decisions should be made solely on the basis of the information and opinions contained herein. The information and opinions contained herein are subject to change without notice.


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