When is it better to use an RRSP, a TFSA – or both?

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Canadian investors face a conundrum each year: How should they decide whether to put their money in a tax-free savings account (TFSA) versus a registered retirement savings plan (RRSP)? And more specifically, is there a way to use both to maximize returns and save on taxes?

The question is a fundamental one all advisors have to address as they help their clients with their investment accounts. While there are some basic rules of thumb, advisors have different approaches when guiding their clients around this issue.

The key difference between a TFSA and an RRSP is that a TFSA is a tax shelter; that is, no taxes will be payable on investment gains. An RRSP is a tax deferral; taxes will have to be paid on investment gains, but only when funds are withdrawn. Of course, the RRSP has the added sweetener of a partial tax refund when clients make the contribution to the fund. But how to decide between the two?

“What I tell my clients is the decision depends on two main things,” says Allan Small, senior investment advisor with Allan Small Financial Group at iA Private Wealth Inc. in Toronto. “Do you need – or could use – a tax deduction? And do you need access to this money anytime soon?”

He tells investors to consider RRSPs as a longer-term investment vehicle in which they can invest money and also get a tax deduction.

“If they need to use some of the money to buy a home or for education, that’s fine, but if they may need the money for something else, then an RRSP is not the right account,” Mr. Small says.

Instead, he would point them toward a TFSA because, unlike an RRSP, withdrawals can be made without any tax implications.

Mr. Small has observed that TFSAs have been taking gradually from RRSPs in terms of investors’ choice for their dollars. A key reason is lifetime contributions can now be as much as $81,500 per person – twice that amount for a married couple.

“That’s quite powerful,” he says. “You combine that with being able to access the money anytime without tax implications, and that’s what investors want.”

But every client’s different, says Melanie Johannink, an advisor with Johannink Financial Solutions Inc. at Sun Life Financial Investment Services (Canada) Inc. in Bolton, Ont. For her, it’s an art and science.

Specifically, she says people shouldn’t just contribute to their RRSPs just for the sake of doing so, but only when it’s likely that they’ll be in a lower tax bracket in retirement.

Ms. Johannink typically focuses on current income as a starting point. If the client is earning $55,000 a year or less, she recommends contributing to a TFSA.

“There’s not a significant tax deferral for you to justify putting a ton of money into your RRSP – and the income tax rebate is not going to give you much,” she says.

Her advice to clients is to contribute to a TFSA throughout the year, then when preparing their annual tax return, see how much an RRSP contribution would help offset their taxes, and if that’s a significant amount, transfer funds from the TFSA into an RRSP contribution.

Meanwhile, Mr. Small says many of his clients use a slightly different strategy – they contribute into their RRSPs and when they get a tax return because of the RRSP deduction, they put those funds into their TFSAs.

For Ms. Johannik, the key is achieving ongoing tax efficiency.

“Sometimes, deferring income isn’t the right thing to do,” she says. “Instead, spread the income out into different baskets to make sure your client is tax-efficient.”

She also points out that future scenarios, such as a spouse passing away, can make large RRSPs problematic.

“You can’t have a crystal ball, so it’s best to make sure you’re tax-efficient through the years.”

When TFSAs make more sense

Other advisors also say that lower-income earners should focus more on their TFSAs.

“People who expect to increase earning and pay more taxes in the future can prioritize the TFSA and use it to contribute more to the RRSP when earnings are higher later on,” says Mary Hagerman, portfolio manager and investment advisor with the Mary Hagerman Group at Raymond James Ltd. in Montreal.

She points out that when individuals start to make money and their earning capacity is set to grow steadily, making initial maximum RRSP contributions to the detriment of the TFSA can be a mistake.

Her preferred choice is to contribute instead to a TFSA and accumulate unused RRSP room for higher-earning years.

“Then, you can dip into the TFSA and make significant RRSP contributions when you start earning more money and get more bang for your after-tax buck,” she says.

However, Ms. Hagerman notes there is a psychological reason why it may make sense to make RRSPs a significant part of client portfolios. That’s because it’s much easier – and tempting – to withdraw from a TFSA than an RRSP as it can be done without a financial penalty.

“Sometimes, if I feel in my conversations with clients that they need some extra incentive to keep money invested for retirement, then a portion will go to the TFSA and a portion into the RRSP,” she says.

Overall, Ms. Hagerman says the TFSA is a “wonderful” tool and when she shows people what it does over time, it’s quite impressive.

“People should be looking to their TFSA if they have money to invest outside their RRSP – and they should consider having a more aggressive profile in the TFSA if they can keep their money invested for the longer-term horizon,” she adds.

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