There is no shortage of opinions on whether it is better to save in an RRSP or a TFSA. It is best to maximize your contributions to both, but realistically most people can’t do this, and so they have to choose. Which option is better depends greatly on how you handle money.
Rational Money Personality
For the very rational person who never makes foolish financial mistakes, the decision comes down to the difference between the tax rate when you contribute money and the tax rate later when you withdraw money. To understand this, it is best to think of RRSP savings as partly belonging to you and partly belonging to the government in the form of taxes.
Suppose that your marginal tax rate is 40% and you’re trying to decide whether to put $10,000 in an RRSP and get a $4000 tax refund or just put $6000 in a TFSA. If your tax rate when you withdraw the money is still 40%, then it is as though the RRSP is holding $6000 of your money and $4000 of the government’s money. Suppose that after decades of growth, your savings grow by 10 times. You would either have $60,000 in your TFSA or $100,000 in your RRSP of which you’d keep only $60,000 after taxes. So, you end up with the same amount of money after taxes whether you use an RRSP or a TFSA.
However, if your marginal tax rate is likely to be higher when you start to spend your savings than it was when you saved the money, then a TFSA is better; otherwise an RRSP is better.
One small advantage of an RRSP is that U.S. dividends have withholding taxes in a TFSA but not in an RRSP.
Another advantage of an RRSP is that it gives downside protection. Suppose that you lose your job and are unable to find other work that pays anywhere near as well, possibly because of poor health or outdated skills. You may be forced to sell off your savings over time. In this case, your lower income makes your marginal tax rate lower and you’ll get to keep more of your RRSP money (after taxes) than you would have in a TFSA.
An advantage of a TFSA is that if you dip into your savings, you’re allowed to put the money back starting the next year. With an RRSP, you lose your room permanently if you make a withdrawal. However, this is really only a significant advantage if you’re later able to completely fill up both your RRSP and TFSA, which is highly unlikely for most people.
Overall, the rational choice is guided by marginal tax rates at the time of saving and withdrawing, with the edge going to an RRSP when the tax rates are close.
Less Rational Money Personalities
All of the previous logic goes out the window if you tend to make common financial mistakes like wasting found money. Sadly, far too many people do not handle money very well and it is best to take your money personality into account when making decisions.
If you tend to spend tax refunds foolishly, then RRSPs are a problem because you’ll lose most of the advantage of the tax break, but will still have to pay taxes later when you withdraw from your RRSP. A potential remedy for this problem is to use a T1213 form to get your refund throughout the year instead of getting a big lump sum at the end of the year.
If the ease of dipping into a TFSA makes this money too tempting to leave alone when you’re eyeing the latest iThing from Apple, then you’re better off with an RRSP. If you would dip into an RRSP as well just to get a tenth pair of nice boots, then the whole question of RRSP or TFSA is moot for you.
If you can’t understand that contributing $10,000 to a TFSA is more valuable than contributing the same amount to an RRSP because a fraction of the RRSP contents really belong to the government, then maybe you’re better off with a TFSA.
Overall, the choice of RRSP or TFSA starts with your money personality. In the end what matters is which type of account will lead to you having the most retirement savings after taxes and after you make all the financial mistakes you tend to make. If you really are very rational with money, then the decision boils down to marginal tax rates.