RRSP over TFSA – Analyzing marginal and average tax rates

There’s a scene in Doc Hollywood where Michael J. Fox, the fresh med school grad, is readying to airlift a young patient out of the small town for emergency heart surgery. Just before liftoff, the aging local doctor shows up and hands the boy a can of pop – Sip, burp, everybody go home.

Theatrics aside, there’s a lesson here for the RRSP vs. TFSA debate.

Since its introduction in 2009, the tax-free savings account (TFSA) has proven to be a powerful tool that opens up countless possibilities for bettering our financial lives. However, when it comes to retirement savings, the tried-and-true registered retirement savings plan (RRSP) should be the default choice for most of the population. Here’s why.

Tax treatment IN, tax treatment OUT

Both RRSP and TFSA give you tax-sheltered income and growth on the investments within them. The key difference is what happens on front and back end:

• RRSP deposits are pre-tax, while withdrawals are taxable;
• TFSA deposits are post-tax, but withdrawals are non-taxable.

Of course, it’s often said that RRSP contributions are tax-deductible, the appeal being the desired refund. However, to convert that to being truly “pre-tax”, all such refunds (and refunds on refunds) must in turn go into RRSPs. That’s already handled through reduced withholding tax on a work-based group RRSP, but with an individual RRSP that’s your own ongoing responsibility.

Base comparison

If your income is taxed at the same rate when contributing and withdrawing, you will net the same amount of spendable cash whether you use the RRSP or TFSA. Using $100 at a 40 % rate and a 10% one-year return (for simplicity, not reality), here is what each yields:

• RRSP $100 deposit + $10 return = $110 taxable, netting $66 spendable
• TFSA $60 deposit + $6 return = $66 spendable

If you are at a higher tax rate going in than out, the RRSP will do better, and vice versa. If you change the example to 40% in and 30% out, the RRSP nets you $77, but the TFSA is still $66. And if your later rate is instead 50%, RRSP nets $55, and once again TFSA $66.

Is it really that simple?

“Same rate” – Marginal or average?

Having made the point about taking care in managing the deductibility of an RRSP contribution, we can’t lose sight that it is indeed a deduction. The benefit is that your RRSP contribution comes off the top at your marginal rate, saving you tax at the highest rate you would otherwise face.

On withdrawal in your later/retirement years, the appropriate measurement is arguably (I’ll come back to this) your average tax rate. Average tax rate is total tax divided by total income. In a progressive tax system where there is more than one bracket, average rate will always be lower than marginal rate.

That in mind, imagine for a moment that there were no contribution limits for either plan type. Even if you were at the same (indexed over time) income level in retirement, the RRSP route would do better than TFSA, because the average rate out must be less than the marginal rate in.

But what’s your own average rate?

In truth, not all your retirement income will come from RRSP savings alone, which brings me back to the arguable point about whether to use the average tax rate as stated above.

Once you begin your Canada Pension Plan (CPP) and Old Age Security (OAS), you have no further discretion whether or not they are paid from year to year. That then forms your foundation lower bracket income, on top of which your RRSP (in the form of a RRIF or annuity draw) is layered. In that case, the applicable average rate should be calculated on the income above this non-discretionary floor. Still, as long as there are at least two brackets, and you were the higher on contribution, this modified average rate will be below your original marginal rate.

It gets more complicated if the OAS clawback comes into play, adding about 10% net to the marginal effective tax rate (METR). But even if you were entitled to maximum CPP and OAS of about $20K, you’d be progressing up through low to mid brackets until you hit the OAS clawback as you neared $80K. Nonetheless, according to my calculations, average rate would still be materially below marginal rate at full clawback around $130K.

Default choice, not dogmatic requirement

To repeat, the point here is that RRSP is the default choice, but that it could be displaced based on other factors.

Factors that bolster RRSP include:

• the fact that most people live on a lower income in retirement, meaning both lower marginal and average rates
• spouses using pension income splitting to bring down their combined average tax rate
• the availability of the pension credit

Comparatively, the TFSA may be favoured when:

• an income earner is at low bracket at saving age
• there are already significant RRSP assets
• a large inheritance/windfall has arisen that affects the timing and/or amount of required drawdown from existing savings

In reality, it’s more about proportionality than a binary RRSP vs. TFSA decision. Having an appreciation for the technical underpinning should help you make better-informed choices and have greater confidence to stay the course in your investments.