Monday, November 26, 2012

RRSP vs. TFSA Debate Misses an Important Detail

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.


  1. There is other considerations to take into account also, such as TSFA can only be used to contribute to Canadian based investments. RRSP can be used to contribute to Canadian and US investments. It also depends how the money is withdrawn, if you only draw a small amount from RRSP every year the tax hit is minimized and the balance will continue to compound.

  2. @Jeremy: You can the same things in a TFSA as you can hold in an RRSP:

    Your idea of withdrawing only a small amount from your RRSP each year only works if you don't have much other income. Otherwise, you'll still pay at a high marginal rate.

  3. can != should. You will pay tax on foreign investments (dividends) in a TSFA

  4. @Jeremy: True. A U.S. stock ETF with a 2% dividend would have a 0.3% per year drag in a TFSA vs. an RRSP. People who have both TFSAs and RRSPs can be strategic about the placement of their investments to avoid this problem.

    My main point is that an RRSP balance has to be discounted by the expected taxes before comparing it to a TFSA balance.

  5. This is a very important point. To make an equal comparison you have to assume that all money you receive as a tax refund for RRSP contributions is reinvested at infinitum for the comparison between TFSA and RRSP to be equal.

    Or, as you say, you can just gross up your original contribution to your RRSP, which is hard if you don't have extra cash lying around.

  6. One thing most of these RRSP vs. TFSA comparisons always assume is that you reinvest the RRSP tax refunds. We know that some folks consider the refund a gift from the government (when in reality it's a loan to the government at 0% interest): for these folks, there is no question that TFSA is the best tool and the whole TFSA vs. RRSP discussion is mostly futile.

  7. @UI: You're right. That's part of the reason why I'm trying to get people to think in terms of making larger RRSP contributions compared to TFSA contributions. Maybe I can get just a few people to reinvest those tax refunds.

  8. This has another implication: asset allocation.

    Someone with equal amounts in their TFSA and RRSP but of two different asset classes might think their asset allocation is 50-50, but it's probably closer to 50-35 or something.

    I've integrated this principle in my asset allocation spreadsheet, where RRSP amounts are reduced by 38% (my most likely tax bracket for withdrawals).

    It's an approximation, but better an approximation than not taking this effect into consideration.

  9. @Anonymous: Well said. It's amazing how often in accounting that effects that are difficult to quantify are simply ignored. This is one way to get things exactly wrong instead of approximately right.

    If your tax rate on RRSP/RRIF withdrawals really turns out to be 38%, then I think your future is looking brighter than average.

  10. Would it be too much to ask for at least one link to an 'expert' committing the error that you're describing?

    If not, you could publish these sorts of posts daily, without any need for any person to commit the straw man error you'd like to make fun of:

    (Some People) talk about (thing), but they don't understand (really simple facet of that thing).

    (Some People) talk about their income, but they don't understand that you have to pay taxes.

    (Some People) talk about their taxes, but they don't understand marginal tax rates.

    (Some People) talk about the price of cereal, but they forget about milk.

    It's the gift that keeps on giving.

  11. @Anonymous: Fair enough. Frequently I do point to an example of a flawed way of thinking when I criticize it, but in this case it seemed like too much of a poke in the eye to point out how wrong the writer was.