Your TFSA Should Be Your Income Engine, Not Your RRSP

Canadians love investing in tax-sheltered and tax-deferred accounts.

Studies show that most Canadians keep their money in Registered Retirement Savings Plans (RRSPs) and Tax-Free Savings Accounts (TFSAs), the two main tax-advantaged accounts available in Canada. The TFSA lets you contribute, grow and withdraw money tax-free. The RRSP lets you grow, but not withdraw money tax-free; in exchange for the lack of tax-free withdrawals, you get a tax deduction for contributions.

So, both RRSPs and TFSAs have their benefits. However, I’d argue that TFSAs are basically better, particularly for Canadians who are employed and trying to supplement their salary with investment income. In the subsequent paragraphs, I’ll explain how I came to this conclusion.

What RRSPs have going for them

Before going any further, I should clarify that I think that RRSPs have a lot going for them. They let you grow money tax-free for decades and decades, boosting your after-tax returns. They give you generous tax breaks, resulting in up to $10,000 worth of tax savings per year. And although they are taxable on withdrawal, RRSPs let you defer withdrawal until you are retired, and presumably in a lower tax bracket than you are in now. So, RRSPs have many benefits.

With that out of the way, let’s look at why TFSAs are ultimately better.

The TFSA withdrawal advantage

The reason why TFSAs are better than RRSPs — at least for Canadians who plan on cashing out their investments while still working — is that they offer much more flexibility around withdrawals. If you withdraw investments from a TFSA, you don’t need to pay any taxes at all, or even report anything to the Canada Revenue Agency (CRA). If you withdraw RRSP investments, you’ll probably have to pay taxes, and you’ll definitely need to let the CRA know about it.

We can illustrate the TFSA advantage with an example. Imagine you held $100,000 worth of Fortis (TSX:FTS) stock in an RRSP. If you did, you’d have a position with considerable income potential — which has bearing on which account you’d be better off holding your stock in.

Fortis is a dividend stock with a quarterly dividend of $0.64, which adds up to $2.56 per year. The stock currently costs $74.06, which, combined with its $2.65 annual dividend, gives us a 3.45% dividend yield. So, you get $3,450 worth of dividends on a $100,000 position each and every year — potentially more, since Fortis’s management tends to up its dividend payout over time.

So, we have $3,456 worth of dividend income coming in from Fortis each and every year. The question is, how much tax would you pay on that in an RRSP?

The answer is, “it depends.” RRSP taxes go off of withdrawal amounts, not stock returns. If you took out less than $3,456 worth of dividend income from your RRSP in a year, you’d pay less than you would on the full amount. So, keeping money in your RRSP saves you money.

Nevertheless, you pay your entire marginal tax rate on RRSP withdrawals. Your “marginal tax rate” is the tax rate you pay on an extra dollar of income. If your marginal tax rate is 50% and you take out an entire year’s worth of dividends from your $100,000 Fortis RRSP position, then you pay $1,728 in taxes. If you hold the same Fortis shares in a TFSA and withdraw the same amount of proceeds, you pay nothing. So, if you pay considerable taxes and withdraw from your investment accounts regularly, you do much better with a TFSA than with an RRSP.