RRSP’s or TFSA’s: Which is the better investment?

A common question I’m asked is which is a better investment; an RRSP or a TFSA?

Well, let’s take a closer look. Before you decide whether to contribute to an RRSP or a TFSA, you’ll want to consider your goals and your current and future tax rate.

One main consideration is what your marginal income tax rate is now versus what you expect it to be when you plan to make a withdrawal. Here are two scenarios to consider:

Scenario one

Your tax rate is expected to be lower when you’re withdrawing money than it was when you were contributing money.

Your initial contribution (40% tax rate)

TFSA – $600 deposit grows to $1,592

RRSP – $1,000 (assumes that tax refund is reinvested) deposit grows to $2,653

Your withdrawal in 20 years (30% tax rate)

TFSA – After tax – $1,592

RRSP – After tax – $1,857

Recommendation: RRSP first, then TFSA

Scenario two

Your tax rate is expected to be higher when you’re withdrawing money than it was when you were contributing money.

Your initial contribution (30% tax bracket)

TFSA – $700 deposit grows to $1,857

RRSP – $1,000 Deposit (assumes that tax refund is reinvested) grows to $2,653

Your withdrawal in 20 years (40% tax rate)

TFSA – After tax – $1,857

RRSP – After tax – $1,592

Recommendation: TFSA first, then RRSP

Ultimately, one isn’t better than the other. There can be a place for both an RRSP and a TFSA in your financial plan.

An RRSP can be more beneficial if you’re currently earning a high income because it helps you defer taxes until later in life when you may have a lower tax rate and pay less tax overall.

On the other hand, your TFSA can be more tax-effective if you expect your tax rate to be higher when you withdraw money than it is when you contribute money. This makes a TFSA suitable if you’re in a lower income bracket but expect to be in a higher tax bracket later.

Your advisor and investment representative can help you decide whether it’s more beneficial to pay taxes on your income now or in the future, based on your unique situation.

Assumptions: $1,000 pre-tax income in an RRSP, an equivalent after-tax amount contributed to a TFSA based on 30 and 40 per cent tax rates. Growth assumes a five per cent annual rate of return for 20 years.