Mike from Four Pillars mentioned in a comment that the TFSA offers us a new horse to beat to death because we can now endlessly argue over whether a RRSP is better than a TFSA or does it make more sense to pay down the mortgage instead. In that spirit, let’s first consider the easier debate: is it better to contribute to a RRSP or a TFSA?
It is much easier to figure out whether contributing to a RRSP is better than a TFSA because it largely depends on just two variables - the tax rate at which contributions are made and the tax rate during the withdrawal phase. If the two tax rates are identical, the TFSA is better option because it is more flexible and withdrawals do not affect income-tested benefits.
I suspect that a lot of people (your humble correspondent included) will fall in the category where their tax rates in the accumulation phase are higher because they are in their peak earning years and are paying the highest tax rates of their working life. Presumably, when they are retired they will be paying much lower taxes. Since their contribution tax rate is much higher than the withdrawal tax rate, a RRSP contribution is likely to be the better option. For the few Canadians who pay a higher rate in their withdrawal years than in their contribution years, a TFSA is probably the superior option.
The RRSP/TFSA versus mortgage paydown is a much harder debate because the right answer depends on so many assumptions made about the future. At first glance, it seems like a no-brainer because investments within a RRSP or TFSA need to earn higher after-tax returns than the low interest rate on mortgages today. However, this is easier said than done. Many experts believe we are in an era of low returns for all asset classes (say 7% for stocks and 4% for bonds) that a 5% guaranteed after-tax return that can be obtained by paying down the mortgage starts to sound very good. Also, while markets have provided generous returns in the past, the average investor has lagged the market returns badly due to chasing performance and not controlling expenses.
Unfortunately, if you have X amount of dollars, it is hard to say which option would be the most profitable pick. But, picking any of the three options would be a good move because the bottom line is you are saving money. In an era where the national savings rate is close to zero, that’s a wise move.
Let the flogging begin!
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26 responses so far ↓
1 moneygardener // Feb 27, 2008 at 8:50 pm
Good summary and good ending. The TFSA does offer one very important (non financial) benefit over RRSPs in that you can access it at any time, without tax. By ‘non financial’ I am referring to the fact that one can rest assured that the money is there for them for withdrawal at any life stage without a large tax hit or loss of contribution room as consequences.
2 Tom // Feb 27, 2008 at 9:27 pm
TFSA offers a great option for saving for a house purchase, no HBP to pay back, especially in the first few years after purchasing a house when money can be a little tight.
3 Bryce // Feb 27, 2008 at 10:56 pm
What if you used your TFSA to contribute to your RRSP. Let’s assume you put $1000 a month into the account and you made 1% interest per month (just using that number for the math). After 5 months you would have contributed the maximum $5000 and the account balance would be $5150. Then take that money out and contribute it to your RRSP. You now get a tax refund on the $5000 and the extra $150 you didn’t ever even pay taxes on and you now have a contribution room of $5150 in your TFSA. Rinse and repeat.
4 Bryce // Feb 27, 2008 at 10:58 pm
Okay that sounds pretty tedious but I think the principle of only making RRSP contributions out of your TFSA makes pretty good sense after a couple years when it’s been build up.
5 Bryce // Feb 27, 2008 at 11:07 pm
But I guess the gain from that is break even if you are already making regular contributions and have filled out a T-1213. For irregular contributions I think it makes sense.
6 fox // Feb 27, 2008 at 11:20 pm
I dunno. I max out my RRSP at the beginning of the tax year. I then use T-1213 to avoid the massive refund. Since I don’t have a mortgage, I suppose I could just max out the proposed TFSA at the beginning of the year as well. Let the compounding begin!
7 Four Pillars // Feb 28, 2008 at 12:11 am
I think you should have included RESP contributions into the mix.
Big time cage match - RESP vs RRSP vs mortgage vs the newcomer from parts unknown…TFSA!
Mike
8 graham // Feb 28, 2008 at 1:16 am
While choosing Home mortgages, I personally like to suggest that Home buyers can choose from several loan terms: 15-year, 20-year, 30-year, or 40-year. Lenders offer a variety of loan options, which create affordable living. Because of low interest rates, buyers can take advantage of a low fixed rate. Furthermore, there is also the popular interest-only mortgage option for those buying homes in overpriced markets.
9 CheapCanuck // Feb 28, 2008 at 2:55 am
Bryce - In order for your plan to work you would have to have some sort of guaranteed (read low ROR) investment in the TFSA. If you bought Stocks, mutual funds, ETFs etc then you face the very real possibility that the value of your TFSA account may be lower than the $5000 you have contributed to it throughout the 5 months. If this happened then you would have less than $5000 to put in your RRSP, and would sacrifice some of the tax refund you otherwise would have enjoyed. Better off putting $1000 a month directly into the RRSP and let it compound in there.
10 MillionDollarJourney // Feb 28, 2008 at 8:30 am
Bryce, another thing, I don’t think the TFSA contribution room increases with growth. I think it’s $5k / year + inflation. So if you withdrew the $5150, and you wanted to redeposit in the same year, you would have the max contribution room of $5k.
11 Canadian Capitalist // Feb 28, 2008 at 8:37 am
FT: When you withdraw money out of the TFSA your contribution room increases by the same amount. In Bryce’s example, let’s say he contributed $5,000 at the beginning of the year and has no other room available. If he withdraws $5,150 his contribution room at the end of the year will be $5,150. Next year, the room will be $10,150.
Mike: Yes, I think RESP vs TFSA is a match up we have to consider.
12 FourPillars // Feb 28, 2008 at 9:41 am
I was thinking that the TFSA should replace the trust account as an alternative to the RESP for those people who don’t like the free 20% grant.
The TFSA is clearly better than a trust account for saving money for your kids.
13 Canadian Dream // Feb 28, 2008 at 10:01 am
HA! I’ve got a post up today as well flogging the same idea. *grin*
I agree that the answer for all this is “it depends”. People may not like the answer, but it is true.
Tim
14 TonyR // Feb 28, 2008 at 10:30 am
The great benefit of the TFSA is that it’s a savings vehicle that (using a football ananlogy) it can play free safety for you. Put core amounts into RRSPs, RESPs, mortgage, etc. and the rest into the TFSA. Then years later you can decide whether to pay the remainder of your mortgage, top up retirement income, or pay the tutition when your child(ren) unexpectedly get accepted to Harvard or decide to pursue a PhD.
RRSPs are no brainer if you’re in the highest tax bracket (unless you have a defined benefit pension) but things get murkier once you contribute enough to bring your taxable income down to the bracket threshhold and/or enought to start moving into the next tax bracket at retirement. Personally, I think that’s when the TFSA becomes interesting. Using rough numbers, investing the max for 20 years in a TFSA should net you a yearly tax-free withdrawl of about $10,000.
15 Jamie // Feb 28, 2008 at 10:41 am
I’ve read in a few places that the TFSA is roughly equivalent to the American Roth IRA and that the RRSP is roughly equivalent to the 401k. Most of the personal finance advice I’ve read is written from an American perspective and the advice generally goes like this:
1. Contribute the maximum amount to your 401k that is matched by your employer
2. Contribute the maximum amount to your Roth IRA
3. Contribute the remaining maximum to your 401k
Why is it that the Roth IRA seems to be the clear “winner” in the USA but the TFSA doesn’t necessarily have a big advantage over the RRSP here in Canada. I suspect it has a lot to do with the different tax structures in the two countries, but I just don’t know enough about it. Can anyone enlighten me?
(As an aside, this is why I love this site and a handful of others like it. It’s hard to find good financial advice from a Canadian perspective.)
16 Leslie S // Feb 28, 2008 at 11:04 am
Thanks to time and compound interest, someone who is able to put $5,000 per year into a TFSA for 50 years and earn 7% in an equity etf will accumulate over $2 million, TAX FREE. Of the $2mm, $1,750,000 will be dividends and capital gains received TAX FREE. For sure the minute a kid turns 18 he/she should start saving as much as possible in a TFSA. If at some point in the future they have RRSP room and need the tax break, some or all can be contributed to an RRSP.
On another note: for a low income individual who has little chance of saving enough in an RRSP to make it worthwhile (considering the clawbacks of government benefits with each $ of withdrawal), this is the best way to save for retirement. They probably don’t have enough income to take advantage of the RRSP tax deferral anyway. Even saving $30 per month (that’s only $1 per day folks!) can go a long way to growing something to supplement the CPP and OAS. This may not apply to many of the readers of these forums but maybe you know someone who’s in this situation.
17 Canadian Capitalist // Feb 28, 2008 at 11:08 am
Jamie: Unfortunately, I don’t know all the rules of 401k, Roth IRA etc. Personally, I’ll first max out the RRSP because the average tax on my contributions will likely be much less than the average tax on withdrawals. Of course, we are talking about future withdrawals and who knows what the tax rates in the future will be but I can’t imagine the lowest brackets having as high a tax rate as higher brackets today.
That said, I won’t fully ignore TFSAs because between a taxable account and a TFSA, it is a no brainer.
TonyR: The TFSA will be a great place for other savings goals, even education savings. I think with the advent of the RESP, it doesn’t make sense to contribute more than $36K at which the full grant can be obtained.
18 Jon D. // Feb 28, 2008 at 11:34 am
Personally, if you are ’stressing’ about where to put all your money between your RSP and mortgage or new TFSA, then you need to have a kid or two - that will fix up your problems pretty quick!
19 Colleen // Feb 28, 2008 at 3:34 pm
Amazing! You guys are a wealth of information.
Jon D. - very funny
Leslie - great thoughts
I just want to pass on my thanks to all of you PF Bloggers who sum up for the rest of us. I wouldn’t be me today if it was not for you.
20 TonyR // Feb 28, 2008 at 3:45 pm
Jon D: AMEN! But of course once you have children the problem becomes how to catch up on RRSPs AND sleep.
CC: Exactly. Personally, I hope to use it to fund a trailer in Arizona 20-30 years from now. Just don’t call the community a trailer park. I hear they don’t like that.
21 Someone // Feb 29, 2008 at 12:36 pm
The TFSA can only be used for people aged 18 and over. So unfortunatly it can not be used as a trust acount for your kids. But almost any way you do the math comparing it to RRSP’s, RESP’s or paying down mortgages it wins every time. That is the power of compounding interest and not paying tax on it at the end. The real question to be answered is how disciplined are canadians. At least the RRSP and RESP have tighter restrictions for withdrawing money making them less attractive to get a hold of the money. The real winners with the TFSA are the ones who can max it out every year and keep the money in as long as possible.
22 Canadian Capitalist // Feb 29, 2008 at 1:24 pm
Someone: That’s a great point about TFSA. Because it is so flexible, there will be temptation to take money out for spending. That’s not always a bad thing because we have to balance spending today against saving for tomorrow but the question is how many are responsible about it.
I don’t think the TFSA will be superior to a RRSP because the RRSP technically allows us arbitrage the higher tax rate during contribution against the lower tax rate during withdrawal.
23 MikeG // Mar 7, 2008 at 3:44 pm
Im surprised no one has thought of this yet.. the TFSA is a very young thing, politically. There’s still the possibility it could be squashed by the next pary/election..
just a thought..
24 Michael // Apr 5, 2008 at 10:12 am
Rethink/plan your RRSP to give about 15,000$ in todays dollars per year to take advantage of the tax credits such as basic personal amount, age amount, and pension amount. Dump your refund and contribute up to 5K a year into your $ in a TFSA (if you are young, use the same types of investments).
RRSP + CPP + OAS + TFSA = GOOD RETIREMENT!
You will get FULL GST, will be considered low income, and if you live in Ontario, you get some wealthy ontario credits (occupancy cost because your income is so low).
OR
Prepare for a 30K RRSP in todays dollars, split in half with your wife so she can be a stay at home mom and still live fairly comfortably with one source of income.
25 Weslee // Apr 16, 2008 at 2:17 pm
How does one go about setting up this savings account in order to begin the process ?
26 IceSpeed // May 6, 2008 at 10:36 pm
Guys - Great points.
Just wanted to also add that if you withdraw from your TFSA you will only get that contribution room back Jan 1st of the next year. So for e.g. if you contribute $5000 in Jan 2008 and withdraw $2000 in Feb 2008 you will only be able to put the 2K back the following Jan 2009 o/w you will be taxed for over contributing.
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