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.
- the free (if used for education) CESG money provides the superior return, as shown in RESP vs RRSP - the Best Approach is Clear on the CanadianFinancialDIY 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)
- 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.
6) Taking a Loan to Make the RRSP Contribution Works if,
- tax refund is either reinvested or used to pay down the loan - NOT spent (see RRSP Loans: What to do and Not to do and RRSP Loans: and Another Thing - Timing is Crucial on CanadianFinancialDIY)
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.