TFSA or RRSP? The answer isn’t only about tax rates

At this time of year, most advisors get asked if it is better to invest in a TFSA or an RRSP.

I was asked that exact question at a recent speed networking event. I had just introduced myself as a financial planner to a man in his mid-40s and before I could ask him what he did, he blurted out, “So which is better, TFSA or RRSP?”

I paused for a moment, and then said, “For you, a TFSA is the better choice.” He stared for a full five seconds — a long time in a speed networking session — and then asked, “Why do you say that?”

“Because you don’t have a financial plan,” I answered. “If you did, you wouldn’t need to ask me which one is better.” Before he could say anything else, the bell rang and it was time to move to the next person.

Read: What new tax brackets mean for your clients

So, which one is better?

Conventional wisdom says if your tax rate when you invest the money is higher than when you take it out, you’re better off within an RRSP. If your tax rate will be higher when you take the money out compared to when you save it, then you’re better off with a TFSA. If you expect no change, it makes no difference.

But this advice assumes tax-neutral contributions: the amount contributed to the TFSA is grossed-up for the tax refund so that the out-of-pocket cost of the RRSP contribution is equal to the TFSA contribution.

To perform the gross-up, you have to apply the following formula: TFSA contribution / (1 – tax rate). So, in a 45% tax bracket, a $5,500 contribution to a TFSA has the same after-tax value as a $10,000 contribution to an RRSP ($5,500 / 55%).

Problem is, many people (especially those who do not have advisors) will not calculate the gross-up. Or, they cannot afford to finance the added amount until they receive their tax refunds.

And, people without financial plans often do not invest the tax refund from their RRSPs. So, the only way that contributing to an RRSP creates more after-tax income in retirement when compared to a TFSA is when RRSP contributions are grossed-up for taxes.

Read: Do’s and Don’ts of RRSPs: Golombek

Example

Isaac is a 45-year-old single man. He lives and works in a small town in Ontario and makes the 2015 average full-time wage of $58,500/year. Although he expects to receive maximum CPP and OAS, those programs will not provide him with enough after-tax income in retirement.

Over the past year Isaac has saved $5,500, but he’s not sure if he should contribute this to a TFSA or an RRSP. Also, he expects to be able to save this amount each year in the future; as his income increases with inflation, he feels he’ll be able to increase the amount he saves accordingly.

Assumptions used in the analysis:

Isaac was born Jan 1st, 1971
Retirement begins Jan 1st in the year Isaac turns 65
Inflation is 2.5%
Return on investment is 5.0%
Life expectancy is 90
He’ll receive maximum CPP at age 65 & OAS at age 67
Government benefits are indexed to inflation

Using financial planning software, I entered all of Isaac’s information and ran four scenarios.

Baseline: no saving to establish after-tax income from CPP & OAS.
$5,500 to RRSP; contributions indexed for inflation; tax refund is not re-invested.
$5,500 to TFSA; contributions indexed for inflation.
$7,818 to RRSP; contributions indexed for inflation; $5,500 grossed up for a tax refund of $2,318 ($7,818 X 29.65%, his marginal tax rate in Ontario); refund reinvested.

Annual After-tax Income

The $5,500 contribution to an RRSP resulted in a Maximum Sustainable After-tax Income (MSAI) of $40,600/year ($24,800 in today’s dollars).

Read: Essential tax numbers: 2016 update

The same $5,500 contribution to a TFSA resulted in a MSAI of $42,500/year ($25,900 in today’s dollars).

When the RRSP contribution is grossed-up for income taxes to $7,818, the MSAI is $44,600/year ($27,200 in today’s dollars).

Total lifetime MSAI (excluding gov’t benefits)

When you compare the same dollar amount invested in an RRSP and a TFSA, the TFSA provides 21% more total lifetime after-tax income to Isaac. When grossed-up for taxes, the RRSP contribution provides 18% more total lifetime after-tax income when compared to the TFSA.