TFSAs versus RRSPs

Tax-Free Savings Accounts (TFSAs) were introduced in the 2008 Federal Budget and accounts could be opened starting on January 1, 2009. TFSAs provide an alternative to the Registered Retirement Savings Plan (RRSP) program. In a TFSA, after-tax money is contributed (that is, there is no tax refund for the contribution) and compounds tax free. No tax is due on withdrawal. They thus are similar to the US Roth IRA, but are more flexible because there is no minimum age for withdrawal. RRSPs, on the other hand, generate a tax refund on contribution. The funds also compound tax free but are taxable on withdrawal.

This article compares both types of registered accounts in detail to help investors choose which one to choose for different goals (e.g., short-term savings versus retirement) and which one to contribute to first, when applicable.

Saving for short and medium term goals
TFSAs are typically preferable for short term and medium term goals, such as emergency funds or special-purpose funds designated for future purchases (saving for a car, etc.). This is because no taxes are paid on TFSA withdrawals, and the contribution room is not permanently lost. After a withdrawal, you can recontribute the funds starting the following January 1st. In contrast, when you make a RRSP withdrawal, tax is due and the contribution room is permanenty lost.

Note that a third option to consider, when saving for short term goals, is a non-registered (taxable) account. Sure, the interest will be taxed, but that leaves registered account space available for longer term goals.

Saving for retirement
When saving for retirement, a good strategy is to contribute to both a RRSP and TFSA, providing you have the means. If you have to choose, see the next section.

TFSAs versus RRSPs
You should be aware of the differences between TFSA and RRSPs so you can make an informed choice, if you have to choose.

Comparison table
The following table compares TFSAs versus RRSPs.


 * a. At that point, you have to choose between three options (more than one can be selected):
 * cash out the RRSP (withdrawal amount is added to taxable income), and/or
 * purchase an annuity, and/or
 * convert the RRSP to 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).

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, 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 &times; Total_Return &times; (1-Withdrawal_Tax_Rate) / (1-Contribution_Tax_Rate) .... Equation 1

Or, more simply:


 * RRSPafter-tax = TFSA &times; (1-Withdrawal_Tax_Rate) / (1-Contribution_Tax_Rate) .... Equation 2

Using this equation, for new funds and the same return, 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:


 * {| class="wikitable plainrowheaders"

! align="center" |Initial Contributions ! align="center" |RRSP ! align="center" |TFSA ! scope="row" | Gross Contribution ! scope="row" | Tax Refund ! scope="row" |Net Contribution
 * +Starting Values
 * $1667
 * $1000
 * $667
 * $0
 * $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:


 * {| class="wikitable plainrowheaders"

! align="center" |Results after 10 years ! align="center" |RRSP ! align="center" |TFSA ! scope="row" |Compounded Value ! scope="row" |Tax Due ! scope="row" |After-Tax Value
 * +Final Values
 * $3333
 * $2000
 * $1333
 * $0
 * $2000
 * $2000
 * }

The after-tax values are identical.

Other aspects
The impact of foreign withholding taxes gives an advantage to the RRSP vs. TFSA, especially in the case of US-based exchange-traded funds (ETFs) and stocks.

TFSAs versus RRSPs: a lifecycle model
It is obvious that low income individuals saving for retirement should choose a TFSA over a RRSP: during retirement, any withdrawals from a RRSP will reduce the Guaranteed Income Supplement (GIS) at a rate of 50 to 75 cents on the dollar, whereas TFSA withdrawals do not affect government transfers (see GIS: maximizing benefits).

But what is the income level at which RRSPs become more attractive? Horner (2011) uses a lifecycle model to answer this. The model assumes that households save just enough during their working years to maintain consummation during retirement. Income levels, home ownership and family size are taken into account. Many assumptions are made to build the model, but they are explained in detail in the report. The conclusions are that the thresholds over which RRSPs provide a higher lifetime consumption than TFSAs are surprisingly high, ranging from $76,621 for a two-earner, two-parent renter family to $85,545 for a single renter. The author explains that “in every case where TFSA saving is more attractive than RPP/RRSP saving, the retired TFSA saver receives substantial amounts of GIS and refundable tax credits while paying no income tax”. He concludes that
 * ...about one-quarter of households are best off with no retirement savings. Public pension benefits alone provide them with full consumption replacement in retirement. Among the remaining three-quarters of households, about 60 percent would gain from having all their retirement savings in TFSAs.