Tuesday, 9 February 2010

RRSP vs TFSA vs RESP vs Non-Registered Taxable Account?

This is the time of year when many people get around to making their annual contribution to an investment plan. On January 1st, another $5,000 of TFSA contribution room became available to adult taxpayers. January 1st was also the start of another year for obtaining Canada Education Savings Grants through an RESP. The RRSP deadline for 2009 contributions looms on March 1st.

Are you confused about the choices wondering which is best, or do you have limited means and need to choose whether money goes into a TFSA, RRSP, RESP, or perhaps even a non-registered taxable account? Read on for the rules of thumb on which makes most sense under what circumstances.

1) Contribute to Registered Accounts before a Non-Registered Taxable Account
  • tax-sheltered compounding growth in registered accounts is their dominant differentiating advantage. Read The Retirement Savings Debate: Inside or Outside the RRSP Structure? from Philips Hager & North in which they tested and calculated after-tax returns. The Department of Finance reached the same conclusion comparing the TFSA vs a Non-Registered Account. The TFSA, the RESP and the RRSP all take advantage of tax-free growth. The longer the saving and investing period, the more years before the funds will be used, the stronger the effect of tax-sheltering on net, total after-tax wealth for the investor.
  • no requirement to track the cost base for tax purposes in registered accounts avoids some administrative hassle and is a minor advantage

2) Non-Registered Taxable Account is Best for:
  • when registered account contributions have been maxed out
  • as PH&N note, beware of unequal comparisons where some people have claimed an advantage for the taxable account - like using borrowing to invest, which introduces substantial investment risk, not reinvesting the RRSP tax refund, which leaves out a key component of the calculation and assuming unrealistically-low tax rates on the taxable account.
3) Put the First $2500 into the RESP (assumes higher education is one of your goals)
4) TFSA is Best for (see TFSA vs RRSP - Best Retirement Vehicle? by Ed Rempel on the Million Dollar Journey blog):
  • low income earners, especially those under $40,000, and who stay there throughout their life
  • rising income, e.g. those early in their career whose incomes will rise with time or; those who expect a large inheritance that will boost their investment income; the general idea is those for whom the tax rate on withdrawal will be higher than when they contribute are best off in a TFSA
  • very high income earners of $110,000+ (but with either very low retirement savings (under $250k, including pension value, at point of retirement), or with a substantial pension savings amount i.e. over $750k in total value
  • prone to spend RRSP tax refund - to get max RRSP effect you must reinvest the refund
  • plan to use TFSA as an emergency fund - TFSA withdrawals can be replaced later, i.e. the contribution room is not lost, as is the case with RRSPs
  • spouse with low or no income - TFSA enables immediate investment income splitting with spouse, since contribution to spousal TFSA never triggers income attribution back to contributor, but an RRSP has significant such restrictions; a no-income spouse would not earn RRSP contribution room to use anyway.
  • retired but with excess income - i.e. a place to park funds for tax-free growth; this is unlike RRSPs, which must must converted to RRIFs or annuities by age 71 and which means withdrawals / paying tax on income, with no contributions allowed (see Fiscal Agents' Income-Splitting Opportunities and the Income Attribution Rules that May Prevent Them)
5) RRSP is Best for:
  • lower income and/or tax rate on withdrawal; withdrawals are usually lower during retirement, but not always
  • income earners in the $40,000 to $50,000 range and $75,000 to about $90,000 (see CD Howe Institute's Saver’s Choice: Comparing the Marginal Effective Tax Burdens on RRSPs and TFSA)s
  • high income earners, the higher the income, the greater the advantage - true partly because of the higher tax rate being avoided through the contribution along with the tax-free compounding of the amount deferred and partly due to the higher contribution limit on RRSPs ($21,000 in the 2009 taxation year), which allows you to save more
  • investment income splitting with spouse during retirement - after maxing out splitting using TFSAs
  • helping stick with regular saving and not withdrawing un-necessarily or prematurely - the idea of losing RRSP contribution room, or paying taxes on withdrawals before retirement may help avoid dipping into it for discretionary spending; conversely the attraction of the tax refund can help motivate the contribution and the saving that represents.
Handy RRSP vs TFSA Estimation Calculator at TaxTips.ca - enter your own data for your province to verify your specific situation.

6) Taking a Loan to Make the RRSP Contribution Works if,

A Useless Tactic
Contribute to RRSP then Put Refund in TFSA - this does no harm but has zero net value as Is the RRSP Refund as Contribution to TFSA Dipsy-doodle Worth It? on CanadianFinancialDIY explains.

If a choice must be made, then the above can provide a guide. If adequate money is available to fill up the best option, then obviously it is possible to go to the next best for greater savings e.g. if the TFSA or RRSP limits are used up, then go for the other, there are still big tax benefits to be had.

Disclaimer: this post is my opinion only and should not be construed as investment or tax advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a tax professional.


Anonymous said...

Hi there,

I'm getting a Page Not Found when I click on the "The Retirement Savings Debate: Inside or Outside the RRSP Structure?" link to the PH&N website.

CanadianInvestor said...

Anon, thanks for the note. I've fixed the link and it should be ok now.

Anonymous said...

I don't know if I agree that there are no benefits to using your RRSP refund to contribute to your TFSA. If your marginal tax rate is the same when you retire, then RRSPs aren't that useful either way. If your marginal tax rate is lower in retirement, it can still be a good strategy.
I tried the calculator your linked to, as well as this one

Linda Laguna said...

Clearly, there is no question. One should put their money into government-registered accounts despite such things as the RRSP limit, for one. Before you reach the limit, you should take advantage of all it has to offer (tax savings, government guarantee). Sadly only 3% of Canadians actually meet this limit.

Anonymous said...

I don't get very excited about any of these.

The TFSA is only available for a paltry amount, Canadians will be at the same tax rate when they retire and not see much benefit from their RSPs (which tax everything as regular income so there is no dividends or capital gains adavantages), and the RESPs benefit only the rich who can afford them.

Yes, I use these vehicles, but Canadian govt. takes more than it gives. I feel sorry for those who are have lower incomes.