For as long as I have been in the business, the biggest debate about RRSPs has been the debate over which is better: buying RRSPs or pay down your mortgage. There has been lot's written on this topic, here's a few that have tackled the debate:
Debate: RRSP vs Mortgage by Million Dollar Journey
Contribute to RRSP or Pay Down Mortgage from Canadian Finance Blog
I even tackled this topic in my article called The Great RRSP Debates
TFSAs created a new debate
There's a new debate that began in 2008 when Finance Minister Jim Flaherty, announced what he considered to be historical significance in introducing Tax-Free Savings Accounts (TFSA). This year, tax expert Jaime Golumbek is really bringing some real attention to this debate because he is suggesting that more people may want to look at putting money into Tax Free Savings accounts (TFSA). In fact, in some cases, he suggests that TFSAs might even be more beneficial than RRSPs.
Just recently, I cautioned people from thinking that TFSAs are better savings vehicles that RRSPs for retirement where I shared two reasons why TFSAs will not replace the RRSP as the primary way to save for retirement.
The Ins and Outs of RRSPs and TFSAs
In this article, I would like to share some of the math when it comes to debating the use of RRSPs or TFSAs for retirement savings.RRSPs are attractive because you get an immediate tax deduction for the contribution and any investment earnings are tax sheltered as long as the money stays in the RRSP. Depending on your marginal tax rate, a $5000 contribution might translate to a $1250 to $2000 tax savings as a result of the immediate tax deduction. The TFSA does not give you this tax deduction which makes the RRSP deduction pretty appealing.
However, you can't properly compare TFSA with the RRSP by just looking at the tax savings going into the plans. You also have to look into the future when the money comes out of the plans. With the RRSP any withdrawal is fully taxable. That means a withdrawal of $5000 might only net you $3000 to $4000 after tax depending on your marginal tax rate. TFSAs may not give you a deduction when you put the money in but you also don't have to pay tax when you take the money out. If you take out $5000, you get the full $5000.
In both TFSAs and RRSPs, you do not have to pay tax on any investment earnings or growth. You get the benefit of tax sheltered investment growth.
Marginal tax rates make all the difference
If you are debating putting money into the RRSP or TFSA, take a look at your marginal tax rates. The bottom line is RRSPs still make sense if you are saving long term for retirement and your income at the time of withdrawal is in a lower tax bracket than your income at the time of contribution into the RRSP. Here's a great rule of thumb to follow:
- If your marginal tax rate at the time of contribution is greater than your marginal tax rate and the time of withdrawal, then RRSPs have the advantage.
- If your marginal tax rate at the time of contribution is less than your marginal tax rate and the time of withdrawal, then TFSAs have the advantage.
- If your marginal tax rate at the time of contribution is equal than your marginal tax rate and the time of withdrawal, then neither has the advantage.
This is the same logic I apply to the one formula approach to making RRSP decisions.
My Two Cents
RRSPs and TFSAs both have a place for savings. If you have the money, you should do both.
If you don't have the money to do both, then start by looking at what you are saving for. If you are saving to buy a car, go on a holiday or for an emergency, then the TFSA is probably the way to go.
If you are saving for retirement, then my advice is to start with the RRSPs and see if the tax implications now and in retirement work in your favour. If not, then move to the TFSA. When you are not saving for retirement, the TFSAs become much more advantageous simply because there is no tax at withdraw.