In my last post I discussed the differences between RRSPs and TFSAs and where the strengths of each lie. Today I want to discuss how RRSPs are commonly used and how that works in favour of retirees.

Last time we looked at what happens when you withdraw from your savings when you are already earning an income and thus had a steady tax rate applied to your withdrawals. For most people though, you live off of your retirement savings as a primary source of income and so you cannot just look at a marginal tax rate¹. You need to use the full progressive income tax bracket set to apply an effective tax bracket.

Comparison

To keep numbers simple, let’s assume that our hypothetical investors are 30 years old and want to retire at 50 with whatever money is saved in their investment accounts (currently $0). They have $10,000 pre-tax dollars to invest with each year and are in the 30% marginal tax bracket. They are investing in a hypothetically stable market that will return exactly 10% per year forever, so planning should be nice and simple. We will assume they have enough contribution room in their RRSP/TFSA from previous years that they will not need to worry about limits.

Which account will give our investor the most money each year in retirement?

Case 1 - TFSA

If investing in a TFSA each year at a 30% marginal rate, our investor will have $7,000 available to put into their account every year. Plugging this into our trusty compound interest calculator, we see that in 20 years at age 50 our investor will have $441,017.50. Since this investment account can be withdrawn from tax free and it is returning 10% indefinitely, our investor can live on $44,101.75 every year and never run out of money.

Case 2 - RRSP

Since RRSP contributions use pre-tax dollars, our investor is able to put the full $10,000 in their account every year. After 20 years, they will be left with a retirement account worth $630,024.99. This investment account will continue to grow by 10% each year, so our investor should be able to withdraw 10% every year and never run out of money. That gives us $63,002.50 each year to work with.

Since this money is coming out of an RRSP, these withdrawals are fully taxed as though they were regular income. $63k puts our investor in the 30% marginal tax bracket in Ontario. Based on our discussion last time you would think that this would mean RRSPs and TFSAs are exactly the same for this investor ($63k * 70% = $44.1k). However, since the withdrawal amounts are so large and are the only source of income for our investor in retirement, we need to look at the effective tax rate instead of the marginal tax rate.

The effective tax rate for someone in Ontario earning $63k is only 19%. This means our retiree will have $51k each year in retirement, 16% more than if they had invested in a TFSA instead!

So what?

Knowing how the progressive tax system makes RRSPs even more powerful by simply shifting your income tax from one bracket to another, you can use it to your advantage in your own financial planning. Want to retire early? Invest in an RRSP over a TFSA to cut down the time it takes to get to your desired spending level. Want to live it up when you retire? Use the RRSP to give yourself more to work with in retirement. Want to spend more in your saving years? Make smaller contributions to your RRSP than you would to your TFSA to end up with the same amount. Want a bigger safety net to account for fluctuation in market returns in retirement? Your RRSP has got your back.

The only time it really starts to make sense to use a TFSA over an RRSP is if you might need to use the money earlier when you are still earning an income or if you want to spend a lot more in retirement than you earned during your earning years. And of course, if you have used up all of your RRSP contribution room and you still have more money to invest, you might as well toss that into your TFSA.

As with any financial info you get from strangers on the internet, be sure to run the numbers yourself for your own situation to make sure you are making the right decision for you. The numbers in this article are chosen to make the math simple, but the concepts apply just the same to more realistic values as well.

People often wonder when they should use an RRSP or TFSA. Both can be very useful, but if you only have enough extra income to fund one, which should you use? Many of the arguments for or against these accounts are based on conceptual understanding. I will try to demonstrate with cold, hard math where the strengths of each lie.

First, lets clarify what these accounts really are. RRSPs and TFSAs are just containers in which you can store your investments. They are like different types of mugs, and your investments are different kinds of beverages. Some mugs are more portable, some are easier to clean, but any beverage can go in any mug.

If you were to invest your money within an RRSP, you are able to invest your money prior to paying income tax. Because of this you can get more money invested early on. The down side is that any money you withdraw from this account, be it principle, capital gains, or dividends, is all taxed as regular income.

If you invest your money within a TFSA, you are investing money after you have paid income tax, so you won’t have as much money invested up front as you would with an RRSP. The benefit of the TFSA is that any money you withdraw from this account is 100% tax free.

If you don’t use a tax advantaged account, your taxable investments will be contributed like a TFSA (using after-tax dollars). When you receive dividends or interest, you will have to pay tax on those in the year you receive them. If you sell any investments, you will need to pay tax on the capital gains in the year of the sale. Any principle withdrawn is withdrawn tax free since you already paid taxes when you earned the money used to buy the investment.

A TFSA is clearly better than a taxable account, but how do the RRSP and TFSA stack up?

There are a lot of variables that go into this comparison, so it is important that before you make any investment decisions for yourself you evaluate your own specific situation. However, I will try to demonstrate a few different situations that show the strengths and weaknesses of each. I am going to use made up tax rates and rates of return to demonstrate the point and make the math a bit simpler, but I hope that you will see that replacing these rates with amounts similar to your own situation will show a similar comparison.

Sometimes RRSPs and TFSAs are exactly the same

Lets look at a simple situation where you contribute a lump sum to your investment accounts in a year where your marginal tax rate is 25%. You leave this money invested for 10 years and earn 10% each year. At the end of the 10 years, you withdraw the full amount. We will use a 25% marginal rate on the withdrawals as well, indicating that you have had other income in the year. We will assume that you have $10,000 of income that you want to invest and enough contribution room in both your RRSP and TFSA such that you will not exceed the contribution limits of either.

In the case of the RRSP, you are able to contribute the full $10,000 of income without paying taxes on it (if your taxes are automatically deducted from your pay, you may be waiting for a tax refund from the CRA to get this full amount, but if you are self employed or have filled out a T1213 form, you will have that full amount avaible right away). $10,000 invested for 10 years at 10% per year would give you an account balance of $25,937.42. If you withdraw this all in the 25% tax bracket, the amount available for you to spend is $19,453.07.

In the case of the TFSA, you need to first pay tax on your $10,000, so you will only have $7,500 to invest. After 10 years at 10% growth per year you will have an account balance of $19,453.07. Since this account is tax free, you are able to spend the full amount.

In this situation there is no difference between a TFSA and an RRSP. Both give your original $10,000 of income a final buying power of $19,453.07 after 10 years. One major difference is the amount of tax paid. With the RRSP you will have paid $6,484.35 to the government. With the TFSA you will have paid only $2,500. If this situation matches what you expect for yourself, your decision on which option is best may depend on if you love having paved roads and government health insurance or if you just hate giving money to the government.

Sometimes TFSAs are better than RRSPs

Lets looks at a slightly more complicated situation. What happens if you contribute money into your account when you are in a low income bracket (eg. when you are a starving student) and need to withdraw it all in 10 years when you have a higher income. We’ll assume you start in a 10% bracket and end in a 25% bracket.

With the RRSP, you can contribute the full $10,000, grow it to $25,937.42, and spend $19,453.07, just like in the last scenario.

With the TFSA, you will have $9,000 after taxes. In 10 years you will have $23,343.68, all of which you are free to spend.

In this situation, you will have almost $4,000 more with the TFSA. That is nearly 20% better than the RRSP!

Sometimes RRSPs are better than TFSAs

Lets look at one more example. What happens if you contribute money in your high earning years and withdraw in retirement when your income is significantly lower? We’ll assume you start in a 25% bracket and end in a 10% bracket.

With the RRSP, you will again contribute the full $10,000 and grow it to $25,937.42. In this case, since you are in a lower bracket upon withdrawal, you will have $23,343.68 to spend.

With the TFSA, you will have $7,500 to invest, which will turn into $19,453.07 in 10 years, just like our first example.

This time around, RRSPs were the ones to out perform TFSAs by nearly 20%!

Conclusion…?

These three examples show that the advantages and disadvantages of RRSPs and TFSAs strongly hinge on your income level at the time of contribution and withdrawal. TFSAs are straightforward, pay up front investments. RRSPs are “tax deferred” because you end up paying your taxes at some point in the future as if you had that tax rate at the time of contribution.

With what we’ve seen in the examples above, you should clearly use TFSAs if you expect to be earning more in the future and RRSPs if you expect to be earning less, right?

Well, the situation actually gets even more complicated when you start to look at how most people use their retirement savings. For most people, they contribute to these accounts regularly each year and then withdraw from them regularly each year in retirement. I will leave it at that for now, and in a future post I will dig into some of the nuances of these real life behaviours.