Choosing to invest in a TFSA or an RRSP, or both, is dependent on your circumstances and how you think about retirement. The strategy presented in this post recommends using the TFSA first and then the RRSP and presents the reasons why.
Summary of Strategy
Assuming you want to save for your retirement and major purchases, the strategy is to do the following each year:
- – Maximize any company matching RRSP or TFSA contributions.
- – Make sure you have enough pension or RRIF income when retired to use the Pension Income Amount non-refundable tax credit.
- – Save the maximum permitted in a TFSA.
- – Put other savings into non-registered investments or an RRSP.
Summary of TFSA and RRSP/RRIF
If you need background on the Tax Free Savings Account (TFSA) and the Registered Retirement Savings Plan (RRSP), and the associated Registered Retirement Income Plan (RRIF), you can get it by a simple internet search.
In summary, both can use the same investments, both appreciate in value tax free and both have contribution limits.
The TFSA is never taxed and any withdrawals can be reinvested later.
In contrast, the RRSP is tax-deductible in the year of investment and then fully taxable when withdrawn. The RRSP must be converted to a RRIF by age 71 and there are minimum withdrawals required each year (with the objective to exhaust the RRIF by age 90). Once invested and then withdrawn it cannot be reinvested.
Canada Revenue keeps track of your limits and there are strict rules and procedures on moving the funds. Even with these sometimes onerous conditions, being able to grow tax free will result in a significant increase in value when you retire compared to other investments.
The RRSP contribution limit is nominally 18% of your earned income in the previous year, but there is an annual limit which for 2020 is $27,230. It is also reduced by pension adjustments such as the value of the benefits you earned under your employer’s registered pension plans. Details can be found on this Government of Canada page. Any contributions not used in a year are available in subsequent years. (To make use of the full 18%, your salary would have to be over $150,000.)
The TFSA contribution limit changes every few years depending on inflation. For 2019 it is $6,000. If you have not contributed in past years, you can add to this amount any missed contributions. The amounts since 2009 are given in this Government of Canada page. (If your objective is to save 10% of your salary, as suggested below, this would mean that you would be earning about $60,000.)
How Much Can You Save
Putting money aside for retirement or other large expenditures can often be hard to do when there are so many challenges to just paying for living expenses.
There are a number of ways to ensure that you do not spend more than you earn and lots of advice that you can find by searching the internet. In almost all cases the advice results in you having to make a budget and following it. One other very useful approach is to remove your savings each paycheck and put it into a separate account and then force yourself to live on what is left.
Whatever method you use, you need to make sure that you have funds available for the large expenditures that occur a few times each year such as insurance, taxes, car repairs.
You will also have to save (usually over a few year) for such things as holidays, buying a house or buying a car. These savings can be in high-interest savings accounts, short-term guaranteed investments, but not usually stock market investments where your capital is at risk.
Finally, you need to save for your retirement. One approach for gaining financial security in retirement that is still valid after 30 years was popularized by David Chilton in The Wealthy Barber and is summarized in this Wikipedia link. The recommendation is to “save 10 per cent of all that you earn and invest it for long-term growth.”
If you are interested, here are two of my post that are useful in managing your yearly and long-term finances: Easy to Use Budget Method and Spreadsheet and Estimating Savings Required for Retirement. The later post and accompanying spreadsheet lets you set the percent of your salary you want to save and compares it to your expenditures. It also includes government and private pensions. This is a single-person free approximation to that provided by the FinanceBase-Lifetime Finances application which provides many more options, including income taxes and a second person.
The following steps are focused on your retirement using whatever funds are available after you have dealt with normal yearly expenses and multi-year short term future expenses (e.g. house down payment, car, vacations). If you do not have any funds left to do what is suggested below, a closer look at your budget would be worthwhile to free up some money for your future financial security.
Step 1 – Take Matching Company RRSP
Many companies offer matching contributions to group RRSP plans. Many are up to 5% of your salary. If you can afford it, you should take them up on the offer because it is basically free money with the following condition: the company contribution is added to your income but you can claim it, as well as your own contribution to reduce your taxes. Your taxes are reduced by the marginal tax rate for your total income times the total contribution. But, as mentioned above, your income is increased by your marginal tax rate times the company contribution. This is not a bad trade-off because you basically have increased your RRSP by the combined contribution and also get a tax refund on your and the company’s contribution.
Keep in mind that your refund depends on the marginal tax rate for the combined federal and provincial taxes. These rates are given in Canadian Marginal Tax Rates – 2019.
For background, you may find this MoneySense article useful.
If your company offers to match your contribution to a TFSA instead on a RRSP, you should still take it. However, in this case there is no offsetting tax deduction to the added income taxes for the company contribution. You will still be ahead by the company contribution less the marginal taxes that you have to pay.
Step 2 – Determine Your Pension
Before moving on the Step 3, you need to determine if you will have a company pension when you retire.
If you are fortunate enough have a Defined Benefit plan you can calculate approximately how much your yearly pension will be when you retire because they are usually based on your salary and number of years of service.
Many companies have moved to Defined Contribution where they match your contribution. It is more difficult to calculate your pension as it depends on how much you contribute and the investments used. However, you can guess at what you will likely have as a yearly income.
Step 3 – Estimate Your Retirement Income
In addition to the income from steps 1 and 2, you need to estimate all of your other income when retired. This includes the Old Age Security, Canada Pension Plan, investments, etc. These values are not easy to obtain, but as discussed in Step 4, you do not have to be very accurate because you are only determining if you can take advantage of the $2,000 Pension Income Amount non-refundable tax credit . This can be done in a variety of ways, but I have prepared a number of posts that will help you: Understanding Your Canadian Sources Of Retirement Income, Estimating Savings Required for Retirement.
Step 4 – Minimum RRSP You Should Have
There is a $2,000 Federal Pension Income Amount non-refundable tax credit and a $1,000 tax credit for your province. Basically, it means that the first $2,000 of pension income is not taxed, but only if you pay at least $2,000 of taxes. All pension income and RRIF income is eligible for you to claim this credit.
Now you can see the reason for doing steps 1 to 3 first. As detailed in The Minimum RRSP You Should Have, you can determine if you are eligible for the tax credit. Once you add all the pension income that results from the calculations in in steps 1 to 3, you will know if you do not have enough to claim all of the tax credit. If you do not, then you need to invest in RRSPs during your lifetime to make up the additional income.
By age 71 you must convert your RRSP to an RRIF. At that time you must take out a percent of the capital each year and this is then added to your income. The percentage changes each year and are given in RRIF Minimum Payout – 2015 Rates. If you have no other pension income, you should have about $40,000 in and RRSP before you convert it to an RRIF. If you have other pension income, the value of your RRSP can be less.
If you know that you will need the minimum RRSP of about $40,000, you can determine how much you should save every year by using the spreadsheet that is included with the post on Estimating Capital Totals at Retirement. For example, for a person that is 45 years old this year who expects to retire at age 65 and stops contributing to the RRSP at age 65, for the RRSP to be $40K at 71 the amount to be saved each year is $1,150 (using a 3% interest rate). Note this means the you have put away only $23K over the 20 years (1,150 x 20) due to the impact of compounding interest.
If you need less than the $40K, you can reduce the savings proportionally and check it with the spreadsheet.
Step 5 – Maximize Your TFSA Contributions
If you are not in a high marginal tax rate you should put your savings into a TFSA as you will not get a large tax refund. Also, if you are already getting a tax refund due to steps 1 and 4 (matching company RRSP and Minimum RRSP, respectively), you probably should use a TFSA.
I developed a spreadsheet that is part of TFSA or RRSP – Impact of Reinvesting the Tax Refund Using 2015 Rates which shows that even when the tax refund is fully reinvested and both the RRIF and TFSA have the same payout per year, the RRIF does not preserve Net Worth as well as a TFSA. It also makes the case that if you want control over your capital without the government having a hand in your pocket, use a TFSA.
I highly recommend that you always maximize your TFSA contributions after steps 1 to 4 have been dealt with. Depending on how you invest the TFSA contributions, you can always withdraw from the accounts to pay any unexpected expenses without incurring any taxes (as you would with an RRSP). However, do not use the TFSA as a substitute for a high-interest savings account as frequent withdrawals and deposits are likely result in a warning from Revenue Canada that you have exceeded your limits. (This is due to the restriction that you cannot deposit in the same year that you have withdrawn.)
Step 6 – Invest in RRSP or Non-Registered Accounts
Finally, if you have any savings still available, each year you can decide if you want to tax-shelter it in an RRSP or use a non-registered account or a combination. Normally, either option gives you control over how your funds are invested.
However, with an RRSP, once invested you must pay taxes when you withdraw any money.
On the other hand, non-registered accounts such as high-interest savings accounts, stocks, bonds, mutual shares and Guaranteed Investment Certificates, can be used at any time without tax consequences, except as follows: you must pay taxes on any income they earn each year; you must pay capital gains for any capital accounts. There is a lot advice on what you can do on the internet and how much of each type of account you should hold at any age.
It is wise to keep some non-registered accounts and not fully invest in RRSPs to give you the flexibility of having funds if you need them. You also do not want your minimum payout from your RRIFs to be too large and impact other government support programs such as the Old Age Security (i.e. the claw-back).
Keeping Track of Your Accounts
As a closing comment, over your lifetime you will accumulate a large number of accounts, especially if you use the 5-year ladder approach for fixed-term accounts to deal with changing interest rates. For example, you could have at least 5 non-registered GICs, 5 TFSAs, a company RRSP, 5 of your own RRSPs, any number of mutual shares or stocks, a number of savings and chequing accounts. Also, for capital assets, you are required by the Canda Revenue to keep track of the Adjusted Cost Base for each account. While all of this can be done in a spreadsheet, please examine FinanceBase-Accounts which is an easy-to-use account manager that has a lot of features such as tracking your accounts over time and providing a gross and net worth.