RRSP vs TFSA: pros and cons, allowable contribution limits, basic math

On March 25, 2020 Julie Brough CFA®, CFP®, Executive Vice President and Portfolio Manager of Logan Wealth Management hosted a webinar entitled: RRSP vs TFSA: Is there a right answer?  A Video of this webinar can be found here.

 PART 1 OF 2

What are the pros and cons of RRSPs and TFSAs?  What are the maximum allowance contribution amounts?

There is no easy answer to the question RRSP vs TFSA

In an ideal world everyone would be able to contribute the maximum amount to both their RRSPs and TFSAs.  Since the majority of people can’t do that, it’s important to get the right balance between them.  This will be unique to each individual.

RRSP pros:

  • You get an immediate tax reduction; your overall tax bill is reduced, so the government effectively helps you make the contribution
  • Contributions grow tax-sheltered. Savings grow faster since you don’t need to siphon off money to make tax payments

RRSP cons:

  • Amounts withdrawn from RRSPs are taxable to you
  • You must begin to withdraw money from RRSPs at age 72
  • If you make an early withdrawal, you cannot replace that amount at a later time unless there are special circumstances such as when you use the Home Buyers Plan or the Lifelong Learning plan

TFSA pros:

  • Contributions grow tax-sheltered
  • Amounts withdrawn from TFSAs are not taxable
  • There is greater flexibility with TFSAs because withdrawals can be replaced at a later time

TFSA cons:

  • You don’t get a tax deduction on the contribution
  • Contribution limits are set quite low so you can’t accumulate a large amount of savings in TFSAs

Allowable contribution limits

RRSP:  The lesser of:

  • The contribution limit is 18% of your earned income, less a pension adjustment factor if you have a pension
  • The annual maximum limit which in 2020 is $27,230

TFSA:

  • The contribution limit for 2020 is $6,000
  • The cumulative limit is $69,500

For both RRSPs and TFSAs, you can carry forward contribution room indefinitely.  If you don’t contribute the full amount in any given year, you have the freedom and flexibility to do so later.

What would contributing the maximum amount to both an RRSP and a TFSA look like?

Figure 1

At income levels of either $75,000 or $150,000 most people are not able to contribute 26% or 22% of their income to savings, respectively.  This is not realistic for most people.

The (basic) math

Recall that contributions to RRSPs are done on a before-tax basis, whereas contributions to TFSAs are done on an after-tax basis.

Figure 2

Scenario #1: When your marginal tax bracket remains constant

Let’s assume you contribute an identical amount to either an RRSP or a TFSA ($6,000), at a 5% return, with a stable 30% marginal tax bracket, and you look at what happens after a year.

If you contribute $6,000 to a TFSA, after a year, you will net $6,300 (right column of Figure 2).

If you contribute $6,000 to an RRSP instead (left column of Figure 2), your return will be the same: $6,300, but you have to pay tax on that.  At the time you made the initial contribution, it was done tax-free so you saved $1,800.  If you had put this tax savings into a TFSA, it would earn $90 after a year. When you add everything up, the combined total will be the same as if you had contributed to a TFSA: $6,300.

Figure 3

Scenario #2: When your marginal tax bracket decreases

Let’s assume all numbers are the same as in Scenario #1 except that your marginal tax bracket is  50% at the time you contribute, and it moves down to 30% at the time you withdraw.

If you contribute $6,000 to a TFSA, the calculation will be the same since you will be withdrawing the funds at a 30% tax bracket (right column of Figure 3).

But, if you contribute $6,000 to an RRSP instead (left column of Figure 3), you would receive a higher tax savings ($3,000) because you are in the 50% tax bracket. If you had put this amount into a TFSA it would earn $150 after a year. When you add everything up, the combined total will come to $7,560 ($1,560 more than if you had contributed to a TFSA)

Conclusion from a general math perspective:

  • If your marginal tax bracket is likely to remain constant, it makes little difference whether you use RRSPs or TFSAs as your savings vehicle
  • If your future marginal tax bracket is likely to decrease, it is more advantageous to contribute to RRSPs

What to expect in Part 2 of this webinar blog

In the second part of this webinar blog we’ll address the following:

  • How to take advantage of shifts in marginal tax brackets
  • How to find the right balance between RRSPs and TSFAs during retirement
  • How to maximize personal tax credits in retirement and avoid the OAS clawback
  • Overall summary of parts 1 and 2 of this webinar blog.

 

Disclaimer: Please note that the information presented here is intended as general information only.  It reflects the thoughts and opinions of Logan Wealth Management and should not be construed as investment advice. Please consult your adviser to determine whether this information is applicable to your personal situation.