There is no shortage of experts who debate whether you should put your long-term savings in an RRSP or a TFSA. However, they gloss over an important detail: you have to put more money in an RRSP to get the same effective savings as money placed in a TFSA. Taxes make savings in an RRSP worth less than the same dollar amount of savings in a TFSA.
The line of thinking of some analyses goes as follows. Suppose you have $6000 to save. If you put it in a TFSA, it will grow tax-free until you take it out. If you put it in an RRSP and you’re in a 40% marginal tax bracket you’ll get a $2400 tax refund, it will grow tax-free, but you’ll have to pay taxes on withdrawals in the future. So, things balance out to some extent.
What is missed in this analysis is that in the RRSP case, you’re effectively saving less money. If the investment grows to $60,000 over a number of years but your marginal tax rate stays the same, the TFSA will give you $60,000 you can spend, but the RRSP will only give you $36,000 you can spend. Your effective amount of savings is less in the RRSP case.
To make a true apples-to-apples comparison, you should consider different-sized contributions. If you’re considering contributing $6000 into a TFSA, the corresponding amount of savings in an RRSP would be $10,000 (for a 40% marginal tax rate). Note that after you get the $4000 RRSP tax refund, you’re out of pocket $6000 in both cases.
Now when we consider a scenario where your savings grow by a factor of 10, if you’re marginal tax rate stays at 40%, you’ll end up with $60,000 you can spend in both cases. With these two cases as the basis for comparison, we can then go on to look at what happens if your marginal tax rate changes in the future. The rule is simple: if your future marginal tax rate is higher the TFSA will work out better, but if the rate is lower the RRSP will work out better.
Long after you’ve made your choices and have some money in both RRSPs and TFSAs, it’s important to remember that the balance showing on your RRSP will be partly your money and partly government money, but your TFSA balance is entirely your own.