Financial planning:

invest in an RRSP, a TFSA or both?

Published in MapleLine Magazine: Nov.4, 2009

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by Darren Fisk

The 2009 introduction of the Tax-Free Savings Account (TFSA) represents the most important change to the way Canadians save money since RRSPs were launched in the late ‘50s. But the big question is whether to invest in a TFSA, the tried-and tested RRSP or possibly even both?

Let’s first get a firm grasp on some of the innate differences and similarities between both investment vehicles. First and foremost, both RRSPs and TFSAs provide investors with the opportunity of tax-sheltered compound growth for investments held inside each plan. But unlike an RRSP, contributions to a TFSA are not tax deductible, amounts can be withdrawn tax free at any time and withdrawn amounts are added back into your TFSA contribution room the following year.

Which is best? On a very basic level, looking at your pre-retirement and expected post-retirement marginal tax rates can provide you with an idea how to best allocate your investments. If you expect to be in a lower tax bracket during retirement, investing in an RRSP is generally more beneficial. However if in retirement you anticipate being in a tax bracket that is equal or higher than your pre-retirement tax rate, the TFSA may be more tax-efficient.

Hold on; not so fast. Although it’s tempting to settle on a simple rule-of-thumb, the decision on whether you should use a TFSA or RRSP is not that simple – work with an advisor to consider the entire spectrum of financial strategies at your disposal that could ultimately impact your approach.

Even if you anticipate having a lower marginal tax rate in retirement, maximizing your RRSP contributions may not always be the most tax-efficient long-term strategy. Since RRSP withdrawals (directly or through your Registered Retirement Income Fund (RRIF) or an annuity) increase your taxable income, those withdrawals may affect certain government income-tested benefits and credits such as the Old Age Security benefit and the Age Credit.

On the other hand, if your expected marginal tax rate in retirement is equal or higher than during your accumulation years, contributing to your TFSA may not be the best approach either. For example, RRSPs that are converted to a RRIF or an annuity after age 65 can produce income that is eligible for the pension income tax credit, and thus qualifies for pension income splitting with your spouse. Other income splitting strategies such as the use of spousal RRSPs could effectively distribute a portion of your taxable income to a spouse with a lower marginal tax rate in retirement, further reducing your tax bill and reducing the claw-back effect on your income-tested benefits and credits.

So where does this leave us? A TFSA may be better suited for shorter-term goals, such as an emergency fund or saving for a major purchase (no tax on withdrawals / withdrawals added back into your TFSA contribution room the following year). For long-term objectives, RRSPs are generally the vehicle of choice – your money stays invested in the form of taxes and lost contribution room on the withdrawals from an RRSP. The TFSA can also be a powerful retirement savings tool for the disciplined investor.

In many cases, the TFSA should be used as a complementary product, along with your RRSPs. Your personal savings strategy needs to take into account your unique circumstances as well as your short and long-term objectives. MM

Darren Fisk is a consultant with Investors Group Financial Services in Victoria, BC. Phone: 250-391-4737.

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This article was first published on page 11 in MapleLine Magazine (Holiday 2009 issue / Nov.09-Jan.10).