The Registered Retirement Savings Plan (RRSP) and Tax-Free Savings Account (TFSA) are two tax-sheltered/deferred accounts available to Canadian investors. The RRSP provides a tax break on contribution and tax-free compounding until the time of withdrawal. The TFSA provides no tax break on contributions, but it lets you compound and withdraw your money tax-free. The two accounts seem similar at first glance, but on close inspection, they prove to be very different.
This raises an important question: which should you contribute to first, your RRSP or your TFSA? The answer to that question will determine how much of your investment returns you will actually get to keep. In this article, I will explore it in detail, ultimately concluding that it depends on your financial needs.
The RRSP
The RRSP gives you a tax break when you contribute. If you have a 33% marginal tax rate and you contribute $10,000 to an RRSP, you save at least $3,300 on taxes. That should add a lot to your tax refund. Alternatively, if you’re self employed, you could simply adjust your tax remittances to account for the contribution, and enjoy the savings today. However, you need to have a lower tax rate in retirement in order for this tax break to really be worth it. You do get to compound your tax savings for as long as your stock is in the account. But when you hit age 71, you have to pay the piper.
The TFSA
The TFSA’s tax shelter is much more straightforward than the RRSP’s. Once you deposit money into the account, you can buy stocks inside of it. You pay no tax on those stocks either inside the account, or after you turn them into cash and withdraw funds.
To illustrate the difference between the RRSP and TFSA, let’s imagine that you held $10,000 worth of Fortis Inc (TSX:FTS) stock. First, we’ll consider what would happen to the stock’s returns inside of an RRSP, then we’ll consider what would happen in a TFSA.
Fortis is a dividend stock yielding 4.4%. A $10,000 position in Fortis pays about $440 per year, and unlike capital gains – which aren’t taxable unless you sell – dividends are immediately taxable. So Fortis is just the kind of stock that’s in need of some tax sheltering.
If you deposit $10,000 into an RRSP and buy Fortis, you get a tax break that’s calculated as $10,000 times your marginal tax rate. Then you get to hold the stock and watch it compound for as long as you like. When you withdraw the money, you have to pay taxes on it. If you expect to have a low tax rate in retirement, you may ultimately pay less taxes on your FTS shares than you would have during your working life holding the shares in a taxable account. It’s more complicated if your tax rate is high in retirement.
With the TFSA, it’s much simpler. You simply buy your Fortis stock and pay no taxes on it. Then whenever you like, you can cash out the investment, and enjoy the money. Easy peasy.
The big question: Do you need the money soon?
Ultimately, what the RRSP vs TFSA question comes down to is whether you need the money soon. If you’re willing to hold all the way to retirement, then maybe you should invest in the RRSP first. Otherwise, go with the TFSA. The latter account is much more flexible and straightforward in its tax treatment.
