Many Canadians want to know what a better strategy is for retirement, investing in an RRSP or a TFSA. Although, the answer is not necessarily straight forward, when we start with reasonable assumptions which are more likely to be applicable in most of the cases, the opposite answer may be correct to a considerably smaller set of people.
Analyzing the case there are three distinct sets of cases. In the first, let’s assume that the marginal income tax rates in your RRSP contribution rates are identical to those in your RRSP/RRIF withdrawal years. In the second, assume that your marginal income tax rates are higher in your contribution years and in the third your marginal income tax rates are higher in your withdrawal years. Also, to truly compare apples to apples and not to oranges assume that the full income tax refund attributed to the RRSP contributions are invested in your TFSA. RRSP contributions are supposed to start at $6,000, equals to the individual 2019 contribution limit to your TFSA, and increasing by $250 a year.
The most straightforward case to compare the two cases is when we assume that the marginal income tax rate in your contribution years is identical to the one in your retirement years when you are drawing an income from your RRSP/RRIF and also from your TFSA savings. If the annual rate of return of your RRSP/RRIF and that of your TFSA are also the same, the answer is that it does not matter if you invest in your RRSP and save the tax savings in your TFSA or you instead invest in your TFSA only. After tax, you will be able to draw the same retirement income.
Having said this, you can actually invest differently in your RRSP/RRIF compared to your investments within your TFSA. If you allocate your investments within these two groups in such a way that your overall combined portfolio performance is a certain percentage but your investments within your TFSA have higher returns, and higher risk, compared to that of the RRSP/RRIF, than you will actually be better off contributing to your RRSP and investing your tax refunds in your TFSA.
Let’s examine the first case more closely first, namely if we assume that your marginal tax rates are higher at your contribution years than that after retirement. Table 1. below shows different scenarios namely comparing results when your RRSP/RRIF portfolios are invested the same way as your TFSA portfolios and also comparing results with different assumptions of returns:
Table 1.
The table shows that when pre and after retirement marginal tax rates are the same, it is no difference in after-tax retirement income by investing in RRSPs and invest the tax savings in your TFSA compared to only investing in your TFSA. Having said this, results also show that the case of contributing to your RRSP and investing the tax savings in your TFSA would become a better choice by only allocating lower risk and lower return investments within your RRSP/RRIF and higher risk and higher return investments within your TFSA.
Next, take a look at the case of higher pre-retirement marginal tax rates compared to those of post-retirement. Table 2. shows that contributing to your RRSP and investing the tax savings to your TFSA is a better choice and this advantage can be increased even further by allocating lower risk and lower return investment in your RRSP/RRIF and higher ones in your TFSA – while having the same proportionate asset allocation compared to you contributing to your TFSA only.
Table 2.
Last but not least, let’s look at the scenarios when your marginal tax rates are lower during your contribution years compared to that after retirement. Similar to the previous two tables, Table 3. below shows different scenarios comparing results when your RRSP/RRIF portfolios are invested the same way as your TFSA portfolios and also comparing results with different assumptions of returns:
Table 3.
The table shows that when pre and after retirement marginal tax rates are 40% and 50% respectively the after-tax retirement income is actually the highest by only investing in your TFSA and not contributing to your RRSP. Having said this, results also show that in the case of contributing to your RRSP and investing the tax savings in your TFSA the difference between these two scenarios could be made smaller, although it would not be completely eliminated.
Investing in your TFSA
The conclusion from the above is that contributing to your RRSP and investing the tax savings in your TFSA is a better choice for people who expect their marginal income tax rate to be higher or at least equal during their pre-retirement years compared to during their retirement years. On the other hand, for those who expect their marginal income tax rates to be higher in their retirement years than their working years contribution only to their TFSA is the better choice. Also, for those who contribute to their RRSPs and invest their tax savings in their TFSAs the best option is to invest in higher return and return investment in their TFSAs and lower return lower risk investment in their RRSPs (RRIFs). As for most people their expected pre-retirement marginal taxes are expected to be higher than that post retirement contributing to your RRSP and invest the tax savings seems to be the best approach for the majority of the population.
Determining to either invest in your TFSA or RRSP need careful analysis and planning. Fin-Plan can help you in this regard. To ask any question about this article or to book an appointment to look at your particular case, please contact Miklos at nagy@fin-plan.ca. Miklos is a fee-only financial planner, best selling author, finance-related educational course writer, statistician and former Chair of the Canadian Institute of Financial Planners with over 25 years of experience in financial planning for high net-worth and middle-class Canadians. His Fee-Only financial planning website is at www.fin-plan.ca and his Linkedin page is at https://www.linkedin.com/in/miklos-nagy-fee-only-financial-planner/.
Copyright © 2019 by: Miklos A. Nagy
The views expressed in this material are the opinions of Miklos A. Nagy through the period ended 04/20/2019 and are subject to change based on market and/or other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
Investing involves risk, including the risk of loss of principal. All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed.
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