RRSP is a TFSA in disguise

The RRSP seems like this complex investment vehicle with all these rules and restrictions but with a couple caviets it offers essentially the same tax free growth that a TFSA does albeit with a couple gotchas.

How the TFSA and RRSP work.

Before I can explain how a RRSP is basically a TFSA we need to look at how a TFSA and RRSP work.

Taylor the Tax Free Saver

Taylor makes $60,000 a year and sets aside $6,000 for retirement, they like the idea of investing their money "tax free" so they decide to put that money into their TFSA and passively invest it making 7% annually it would grow to $11,800 in 10 years. If they used a TFSA they could withdraw the full amount tax free.

Riley the Retirement Saver

Riley also makes $60,000 a year and sets aside $6,000 for retirement, they like the idea of investing their money and getting a tax refund to increase their retirement contribution! They deposit $6,000 into their RRSP and get a $2,528 refund that that they can add to their initial deposit for a total of $8,528. Passively invested it will grow at 7% annually and will be $16,777, if Riley is still making $60,000 and wants to withdraw the full amount from their RRSP they will have $11,653 after income tax.

Taylor and Riley have basically the same outcome

As you can see in the above example Taylor and Riley used totally different strategies but the result was nearly the same, assuming your marginal rate is the same at deposit and withdraw the effect of an RRSP is identical to a TFSA

Reinvesting your refund

You might believe that comparing Riley and Taylor is an unfair comparison cause Riley invested $2,528 more then Taylor but that money didn't come from Riley, it was actually from the government as a result of commiting initial $6,000 of post-tax income to their RRSP.

Another way to think of what Riley has done is they lent themselves $2,528 in February that they will contribute to their RRSP (in addition to the $6,000) and they will get that back when they claim the tax deduction in April.

In fact if you fill out a T1213 you can have the income tax your employer deducts from your income reduced by $2,528 ahead of time to provide you the liquidity to make the larger RRSP contribution.

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RRSP and TFSA contribution room

Each year Riley and Taylor will get $6,000 in TFSA room and 18% of their reported income as RRSP room, in their case that will be $10,800 ($60,000 x 0.18). To compare these numbers fairly we need to reduce our RRSP room by our marginal rate (this is to compare after tax dollars), in Ontario both people have a marginal rate of 29.65% meaning that the after tax RRSP room is $7,597 which is significantly higher then the amount of TFSA room gathered per year.

We can even simplify this and take the 18% x (100-29.65%) = 12.66%, that means that for a person who makes $60,000 they get 12.66% of their reported income as tax free growth in their RRSP.

We can also run the numbers for "Bob the big spender" making $120,000 at a marginal rate of 43.41% would be 10.19%. When we compare this to Riley and Taylor 10.19% is less then 12.66% but as a portion of their reported income Riley and Taylor only get $7,596 and Bob has $12,228 of tax free growth in their RRSP.

What this means for Canada

Canada has a "progressive" tax policy which means that folks that have a higher income pay higher rates of income tax but many people believe the RRSP is a "regressive" tax shelter because those who make more money, get more contribution room. It is also important to mention that the RRSP does have a limit on annual contribution room of $27,830 so once you hit $150,000 annual income you cap out and stop collecting more contribution room.

Many people in support of the RRSP say that it's a vital shelter for business owners/entrepeneurs who have highly volitile incomes, traits workers and other folks that don't have pensions, etc. as you can deposit in years that you have surplus income and withdraw in years where you are at a deficit which "evens out" your reported income across years.

Personally I am very thankful the goverment is allowing me to defer paying tax on some income until retirement (or some future date) where I will need it. I think their is also a good argument that folks making from $75,000 - $150,000/year are paying their fair share and that we might want to focus on tax policies that effect folks in the $1M+ bracket who likely aren't.

When the TFSA comes out ahead

When you make a withdrawl from your TFSA you can contribute that amount again in January, when you withdrawl from an RRSP you don't get that room back. This means that if you think you will need this money sooner rather than later you should probably use the TFSA so that you get that room back the following year

When the RRSP comes out ahead

The RRSP results in the same withdraw amounts as the TFSA when your marginal rate is the same at deposit and withdraw. If the median retirement income of an individual is $27,000 that means as long as your contributing to your RRSP at an income of more then $54,000 you will more then likely withdraw at a lower tax bracket then you deposited at which increases your effective return by the spread on your marginal rate from deposit to withdraw.

Caveats and Considerations

If you're still not convinced you can read this paper looking at the RRSP in great detail. If you are convinced I should note that there are some situations that may make you hold off contributing to one account over the other.

  1. You are making less then $30,000: Median income in retirement is $27,000 so if you make around that amount you should prioritize your TFSA and even unregistered investing over your RRSP
  2. You are going to buy a house: The home buyer plan allows you to borrow from your RRSP and repay it over a 15 year period, this essentially allows you to use money you owed to the goverment in the form of taxes to use towards a downpayment
  3. You are going to pursue further education: The lifelong learning plan is similar to the home buyers plan and allows you to loan yourself money from your RRSP to use for full-time education and you repay it the 2nd year after leaving full-time schooling
  4. You are going to actively trade: There are rules against actively trading assets in your TFSA but those rules don't apply in a RRSP, this means you can buy and sell securities very quickly without it being considered business income. That being said it's probably better to actively trade in your unregistered account rather then your RRSP
  5. USD Dividends: Anytime there is a dividend paid from a foreign company there is a portion kept as "withholding tax", if the assets are in an RRSP they do not keep that withholding tax. If you plan to get alot of US dividends you should consider keeping those investments in your RRSP
  6. You move to the US: Canada and the United States have a tax treaty which recognizes the RRSP as a retirement savings account but they dont recognize the TFSA. So if you plan on moving to the state temporarily and you won't need the money you may want to roll it into your RRSP to avoid taxable events
If you want to open a TFSA or RRSP checkout this guide here

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