My $0.02 On The RRSP Versus TFSA Debate

I’d like to chime in on the RRSP vs. TFSA debate real quick. My view, and it’s not a fully trained professional one, is that a person should contribute to their RRSP first, and then invest their refund in their TFSA.

Consider this simplified example:

An individual has a taxable income of $40,000 per year. Assuming they made the same amount the previous year, their RRSP contribution room would be around $7,200 ($40,000 x 18% = $7,200). Let’s say that this person uses the 10% rule and puts that portion of their income into savings, but is undecided whether they should put their $4,000 ($40,000 x 10% = $4,000) into their RRSP, their TFSA, or some combination of both.

Assuming this person lives in Nova Scotia, their marginal tax rate (2010) is 29.95%. If they put all of their $4,000 into an RRSP, their refund on that amount would be $1,198. If they put their refund in in their TFSA, they would have $4,000 in an RRSP and $1,198 in a TFSA for a total of $5,198. If they put the entire $4,000 in a TFSA, they would only have the original $4,000.

Using some real quick gorilla math, we can see that the numbers work in favour of making the maximum RRSP contribution possible, and then investing the remainder of funds, including tax refunds, into a TFSA. As this person’s income rises, their ability to fully fund both their RRSP and TFSA will mean they’ll have to make other financial decisions later on.

Advanced Course:

If you want to get real fancy, you could set up automatic contributions to your RRSP with your financial institution. You can then apply to the Canada Revenue Agency to have your deductions withheld at source reduced to reflect your lower income. Then, you could take the difference in net pay and make regular contributions to your TFSA. This effectively gives you your tax refund every payday so you don’t have to wait until April to use this strategy. It also allows you to take advantage of dollar cost averaging over the year.

An intelligent person might ask, “Why not save that RRSP contribution room for a later year when you’re making more money and you’re in a higher tax bracket?” That is an excellent question. I would argue that the time value of money tells me that a dollar today is worth more than a dollar tomorrow. I want my tax refund as soon as I can get it, so it would depend on how far down the road I thought I would jump up to the next tax bracket. If it looks like I’m going to get a raise or a bonus this year that’s going to push me over a big tax bracket (Federal tax jumps 7% from 15% to 22% once you pass $40,970), then trying to time my RRSP contributions makes sense.

Final Thoughts:

The main reason I prefer making the maximum RRSP contribution first, is that it maximizes my tax refund. That $1,198 in the example above would have gone to the government if that person didn’t make the $4,000 RRSP contribution. The funds in the RRSP can be used if absolutely needed and Canada Revenue Agency has implemented the Home Buyers Plan and the Lifelong Learning Plan to allow people to withdraw funds tax free for purchasing their first home or to go back to school.

For people just getting started in their careers, their RRSP funds can substitute for an emergency fund. If you think about it, the emergency fund is only going to be used in… an emergency. So, if you lose your job and your income goes to zero, there is little impact of withdrawing funds from your RRSP except that you will be taxed on those funds as if you were earning a salary. Since you’re only using those funds to replace your temporarily lost salary, then you won’t end up paying any more tax than you would have normally.

The tax refunds I’ve received have always allowed me to either pay off some debt, or to make some improvements to one of my properties. If I chose to, the refund could buy me a trip to a resort down south each year. If you had to choose between going on a trip down south, or letting the Canada Revenue Agency keep your income tax remittance, which would you choose?