TFSAs versus RRSPs

Introduction

Tax Free Savings Accounts (TFSAs) were introduced in January, 2009, and provide an alternative to the RRSP program.

TFSAs versus RRSPs

Comparison	TFSA	RRSP
Main purpose	Meet your savings needs throughout your life (not only after retirement)	Mainly meet retirement needs
Minimum age	18	None
Maximum age	None	71
Maturity date (termination)	None	December 31 of the year in which you turn 71 years of agea
Annual contribution limit	$5,000 (2009 to 2012)	$21,000 (2009), $22,000 (2010), $22,450 (2011), $22,970 (2012)
Contribution limit as a  % of earned income	None - The annual contribution allowance is not tied to income.	18% (Subject to the annual contribution limit)
Excess contributions	Tax of 1% per month or 100% if deemed to be a “deliberate excess contribution”. See overcontribution	Tax of 1% per month (Up to $2,000 in excess contributions are allowed without penalty)
Unused contribution room carried forward	From year to year	From year to year
Contribution room restored after withdrawals	Starting the following year	No
Contribution limit indexed	According to the Consumer Price Index (CPI), rounded to the nearest $500	Based on the increase in the Average Industrial Wage (AIW)
Spousal contributions	No, but one spouse can give the other spouse the funds needed for his/her contribution without being subject to income attribution rules	Yes
Transfer to spouse in the event of relationship breakdown/death	Yes, without affecting contribution room	Yes, without affecting contribution room
Tax deductible contributions	TFSA contributions cannot be deducted from income	Yes
Investment income taxable	No	No
Taxable withdrawal	You can withdrawb funds from your TFSA at any time for any purpose without having to pay tax on the withdrawals but there may be penalties if you re-contribute the withdrawn amount during the same calendar year.	You can withdrawb funds from your RRSP at any time for any purpose but you have to pay tax on the withdrawals
Minimum withdrawal	No	Yes, after you convert your RRSP into a RRIF
Impact on income-tested government retirement benefits and tax credits(clawback of Old Age Security and Guaranteed Income Supplement)	Does not reduce benefits or tax credits	May reduce benefits and tax credits
Tax impact in the event of death	No, if transferred to the spouse, the value of the TFSA is never taxable. If the TFSA is left to a person other than the spouse, the TFSA will be terminated and the investments will become non-registered assets. The income generated by those non-registered assets will be taxable.	No, if rolled over to the spouse

a. At that point, you have to withdraw the amounts accumulated in your RRSP and invest them in a Registered Retirement Income Fund.

b. Subject to the terms and conditions applicable to the selected investments.

TFSAs versus RRSPs Calculator

A TFSA vs RRSP Calculator is provided on the Taxtips Calculator page. Click on TFSA vs RRSP Calculator and follow the directions from there. (No direct linkage to the calculator is permitted).

Effect of Tax Rates

Comparison Using the Net RRSP Contribution

Many people try to compare RRSPs and TFSAs by using the gross contribution - that is, $1000 in an RRSP (before the tax refund) versus $1000 to an TFSA. Unfortunately, making the comparison in this manner greatly complicates the calculation, because to do an "apples to apples" comparison requires that the refund be invested separately and its after-tax return calculated. The comparison can be greatly simplified by using the net RRSP contribution, after subtraction of the tax refund^a, with the final after-tax dollar amount provided by either an RRSP or a TFSA. Both the RRSP and TFSA provide tax-free compounding while funds are inside the account, so tax payable on the non-registered compounding does not need to be calculated separately. This approach gives the following equation:

Money_Out = Money_In × Total_Return × (1-Withdrawal_Tax_Rate) / (1-Contribution_Tax_Rate) .... Equation 1

Or, more simply:

RRSP_after-tax = TFSA × (1-Withdrawal_Tax_Rate) / (1-Contribution_Tax_Rate) .... Equation 2

Using this equation, for new funds and the same return^b, the RRSP is the better approach if the mean tax rate on contributions exceeds the mean tax rate on withdrawals (which is probably the most general case). If the withdrawal tax rate is expected to exceed the contribution tax rate, the TFSA gives a better return. If the tax rates on contribution and withdrawal are the same, the returns will be equivalent.

To show that the relationship in Equation 2 is correct, consider the hypothetical example of a brother and sister, Joe and Jo Anne. Joe is in a 40% tax bracket and wants to contribute to an RRSP. At the same time, Jo Anne wishes to contribute $1000, after tax, to a TFSA. To compare equal amounts of the two contributions, we need to correct Joe's contribution for his tax refund; the appropriate correction for a 40% tax bracket is a factor of 1 / (1-.40) , giving Joe a gross contribution of $1666.67. Both Joe and Jo Anne invest for 10 years and double their money. Jo Anne removes her funds from the TFSA without paying tax. Joe is still in a 40% tax bracket when he withdraws the funds and must pay 40% tax. The two scenarios compare as follows:

Starting Values

Initial Contributions	RRSP	TFSA
Gross Contribution	$1666.67	$1000
Tax Refund	$666.67	$0
Net Contribution	$1000	$1000

Note that the out-of-pocket expenses are the same. Both the RRSP and TFSA now compound tax-free for ten years, doubling in value:

Final Values

Results after 10 years	RRSP	TFSA
Compounded Value	$3333.33	$2000
Tax Due	$1333.33	$0
After-Tax Value	$2000	$2000

The after-tax values are identical.

Footnotes

^aAlthough doing the calculation in this manner does not represent the way most people think of their RRSP contributions, if you put $100 in an RRSP and got $35 back, your net out-of-pocket is $65, not $100.

^bThis equation is not valid when comparing $1 inside an RRSP to $1 inside a TFSA, because the money inside the RRSP has already been "grossed up" by the refund and will have taxes due on withdrawal.

Other Aspects

The tax rate comparison is, however, only part of the story. RRSP money is available only after taxes are paid on withdrawals. Since no taxes are paid on TFSA withdrawals, it makes it a more favourable vehicle for emergency funds or special-purpose funds designated for future purchases. This argument is further enhanced by the regenerated TFSA room in the year after withdrawal vs. lost RRSP contribution room after any withdrawal.

The impact of foreign withholding taxes gives an advantage to the RRSP vs. TFSA, especially in the case of US-based ETFs and stocks.