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Where's the best place for my savings – an RRSP or a TFSA?

October 11, 2013 by Editor, InvestingForMe

That depends. Are you an average Canadian in need of some friendly wise investing reminders or an above-average Canadian who actually knows how to save their hard-earned money more wisely? If you’re an average Canadian the answer is easy: get yourself a Tax-Free Savings Account (TFSA) and just ignore the Registered Retirement Savings Plan (RRSP) because that’s what the math says. But first you need to figure out which type of investor you are.


How do I know if I’m an average Canadian investor?

First let’s look at a profile of an average Canadian investor when it comes to their saving habits and see if you fit:

  • If your family is average, then you and your partner each make $42,200.00 per year, according to Statistics Canada. (The average family income is $84,400.00.)
  • It’s hard to say what’s average when it comes to savings, but Statstics Canada reports that only 24% of Canadians contributed to their RRSPs in 2011, the same as for 2010 & 2009. (Most of the 76% not contributing said they didn’t have any money to make a contribution.)
  • If you’re one of the Canadians that did put money aside, according to BMO survey it turns out you contributed $3,544.00 in 2012, down from 2011's average contribution of $4,670.00 (which is nowhere near the $22,970 you were allowed).
  • If you were fortunate enough to make an RRSP contribution and receive an income tax refund, here’s the next indicator that you’re an average Canadian investor: Did you treat the refunded money as a windfall and spend it? Unfortunately the average Canadian does just that – they spend it, preferring to celebrate this “windfall” by buying new shoes, going out to dinner, or taking a trip. (An above-average saver, on the other hand, knows to take their refund and contribute it to their RRSP or pay down their consumer debts or mortgage balance.)
  • The income tax rate in retirement for the average Canadian will not be much less than it is today, minimizing one of the main benefits of contributing to an RRSP.  (The golden rule when it comes to saving: Contribute savings to an RRSP when your income and income tax rate is high, and then take it out in retirement when your income and income tax rate is much lower.)

Note: Keep in mind that most articles discussing RRSP savings use math geared to those above-average Canadians with large incomes and in the 40%-plus income tax brackets – not very helpful when your income is much lower that is, average, and has you paying taxes at much lower levels.

Let’s look at the math: why the average Canadian investor should get a TFSA (and not an RRSP)

Let’s say you’re an average Canadian making $42,200.00 per year, but you stick with an average RRSP contribution of $4,670.00 for the next 20 years. And just like the average Canadian, let’s say you decide to spend your income tax refunds on new shoes, dinner out and the latest iPad mini. Sound familiar? Well take a look at the numbers below where we compare the different places you can invest your savings and see how you may be hurting your financial future when you simply choose the ever-popular RRSP as your savings vehicle.

 

 

Where is the best place for your savings?

 

Taxable

Accounts

Average RRSP Accounts

TFSA

Accounts

Above-Average   RRSP Accounts

Your Annual Contributions:

$4,670.00

$4,670.00

$4,670.00

$5,331.05 (Including $661.05 Tax Refund)

What do you do with your RRSP income tax refund?

 

Spend it!

 

Reinvest it!

Value of savings after 20 years:

$136,750.01*

$144,626.18**

$144,626.18

$165,098.28**

Savings withdrawn in the 21st year:

$141,864.46*

$140,634.50**

$150,411.23

$160,541.57**

Value of your savings

after taxes are paid:

$141,864.46*

$140,634.50**

$150,411.23

$160,541.57**

(14% more RRSP $s)

Assumptions used for the calculations above:

 

Annual income:

$42,200.00

Starting balance of savings:

$0.00

Annual income in retirement:
(70% X $42,200)

$29,540.00

Annual rate of return earned on savings:

4.00%

# of years contributions made:

20

Years of withdrawals:

(assumes all savings are withdrawn at the end of the 21st year)

One

Income tax rate during contribution period (Average):

12.37%***

Income tax rate during withdrawal period (Average):

6.48%***

*** Estimated with the help of our Income Tax Estimator calculator.

*Lower maximum tax rates on capital gains and dividends would make the investment return for the taxable investment more favorable, thereby reducing the difference in performance between the hypothetical investments shown. **For simplicity, assumes 6.48% income tax rate on the whole withdrawal and not the actual higher income tax rate associated with a large withdrawal from an RRSP. *** Assumes resident of British Columbia.

Member’s Note: Take a look at your own numbers! Use the Income Tax Estimator to calculate your approximate income tax rate today and in retirement. Then use the Taxable vs. Tax-Advantaged Investments calculator in the IFM Tools section to play with your own numbers to see which savings plan is best for you.  

Conclusion: So, what’s the net result of blowing these tax refund “windfalls” for the average Canadian when you decide to save inside an RRSP? Sadly it means less money for retirement and makes an RRSP the worst place to hold your savings. For the average Canadian, the math clearly shows how an RRSP is actually the last place to hold your savings especially when a TFSA gives you $9,776.73 more cash in your pocket ­– the difference between what you would have saved with an RRSP ($140,634.50) vs. what you would save with a TFSA ($150,411.23).  In other words, when you spend your RRSP income tax  “winnings” on new shoes or iPads, you feel great today - but you lose in the long run.

So what makes for an above-average Canadian investor?

Well, there are 3 habits that can make you above average:

  1. You don’t just blow your RRSP income tax refund on stuff! You actually reinvest your refund or use it to pay down your consumer debts and mortgage. (When you do this, that makes you smarter and more disciplined than the average Canadian.)
  2. You have the ability or discipline to save more than $4,670.00 (i.e. the average Canadian RRSP contribution in 2011).
  3. You’re extremely successful and have the ability to save substantial amounts for your future retirement. For example, you not only max out your RRSP contributions for 2013 ($23,820.00), but also max out your TFSA ($5,500 per year starting in 2013).

What to do if you’re already an above-average Canadian investor?

If you fall into category #1 where you’re still saving the average $4,670, but you don’t blow your RRSP tax refunds, the numbers change dramatically. In fact, if you simply contribute the refund to your RRSP, the RRSP jumps to the top as the best place for your savings. The retirement savings math shows the after-tax value of your RRSP savings would jump from $140,634.50 to a whopping $160,541.57 – an improvement of $19,907.07 or 14%! (That’s what you call a nice reward for discipline!)

Note: Taking your RRSP income tax refund and paying down your debts (credit cards and mortgage) is even more powerful. Remember, interest paid on debts is paid with after-tax dollars – so very expensive. In our simple example, using the $661.05 RRSP income tax refund (the difference between $5,331.05 and $4,670 in our table) to pay down your mortgage is more valuable than contributing it to your RRSP – talk with your mortgage planner to learn more.

For those of you in category #2 disciplined enough to save more than the average amount for an RRSP, the math does not change if you save $5,000, $10,000 or $20,000. Without reinvesting your RRSP tax refund the result is the same. You’re best to max out your TFSA first and then contribute to your RRSP.

And for those above-average Canadians able to max out both the RRSP and TFSA limits each year in category #3 above, the question is moot. You max out both, invest wisely, and look forward to a great retirement.

Final answer: it’s not so hard to be an above-average investor!

Each of us has varying abilities to accumulate savings and we all have access to the same savings vehicles (RRSPs, TFSAs, taxable accounts), but it’s our personal discipline that can make a serious impact on our eventual retirement finances. Your choices are simple: either take the refund and blow it (and thereby accept a lower financial status in your retirement), or be smarter than the average Canadian and use the refund to increase your retirement savings or pay down consumer and mortgage debt.

 

P.S. In a perfect world income tax rates will be the same or lower 20 years from now, and this is the assumption in our discussion. However, if income tax rates begin to increase, then the benefits associated with an RRSP will diminish. The benefit associated with contributing to an RRSP when your income and income tax rate is high and then taking it out in retirement when your income and income tax rate is much lower might not hold true.

 

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