Friday, 21 October 2011

RRSP vs TFSA? First, the Numbers

Trying to save for retirement but unable to figure out if putting money into an RRSP is better than a TFSA? Welcome to the party, you are not alone.

Our previous blog post RRSP vs TFSA vs RESP vs Non-Registered Taxable Account took a general look and gave rules of thumb. Now we get more specific in comparing the RRSP against the TFSA.

The Calculator offers a free and quite complete tax TFSA vs RRSP Calculator (see screen shot below) that can compare the two in terms of after-tax cash flows from the working and saving years right through retirement. The customization to one's own circumstances includes all the key factors - province of residence to reflect different provincial tax rates, current age, intended age to convert RRSP to RRIF or to begin receiving CPP, how much CPP and OAS entitlement one will have, pension income other than the RRSP or TFSA, amount of contribution to the RRSP, or TFSA (the latter which the calculator adjusts to make it exactly equivalent after-tax to the RRSP contribution) and estimated future portfolio rate of return within the RRSP/TFSA. Behind the scenes the calculator uses the appropriate tax rates, tax clawbacks and credits to show year by year how much spending after-tax money you end with.

After you select all the variables and click "Calculate" the big blue text line tells you whether the TFSA or the RRSP is best overall. Wonderful!

The Results
We tested across a range of income levels from $35,000 to $120,000 for a hypothetical single 30 year old in the various provinces. The bottom line number we look for is what percent of after-tax disposable income the RRSP/TFSA replaces, the higher the better.

  • TFSA Always Wins for the $35,000 Wage Earner - that's in every province; the result is mainly due to not losing out on benefits like OAS and GIS
  • RRSP Always Wins for All Higher Pre-Retirement Income Levels - MillionDollar Journey's post TFSA vs RRSP - Best Retirement Vehicle? puts the cut-off more precisely at $37,000
  • The Margin of Advantage is Always Quite Small, No More than About 1.5% - that's right, across all income levels and the scenarios discussed below, whether the TFSA or the RRSP wins, the total lifetime cash flows, as expressed in their Net Present Value, and shown at the bottom of the Calculator's Results table, is never very greatly different!
  • TFSA Alone is Not Adequate for High Income Earners - the $5000 annual contribution limit on the TFSA makes it impossible for those at $120,000 to save enough to achieve even minimal 60% income replacement. Thus, in practical terms, the RRSP is a required element for retirement saving for high earners.
Key Scenarios
Next we looked at a couple of scenarios for the assumptions that matter the most: a) portfolio return - instead of our base 3%, we tried 5%, which we dub the "Excellent Market Returns" scenario, and b) savings to be depleted over 20 years (by age 85) instead of our base 30 years, which we call the "Die per Average Life Expectancy" scenario.
  • Higher Portfolio Rates of Return Matter More than How Long the Savings Must Last - Effective investing matters. The results of our scenarios show a much greater effect in retirement disposable income from a change in returns to 5% than shortening the retirement period from 30 to 20 years. A low-cost portfolio that includes a good portion of higher-return, though riskier equities, makes a big difference, as we blogged about in our previous post.
Those are the numbers. Overall, it looks as though the TFSA should be the automatic choice for low earners - those earning $37,000 or less - and the RRSP the preferred vehicle for those in the highest income category. In between, it doesn't seem to matter much.

However, there are other considerations that can change the picture and in our view affect the best strategy, as we will explain in our next post.

Disclaimer: this post is my opinion only and should not be construed as investment 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 professional advisor.

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