Max Out Your TFSA, and Forget the RRSP!

rrsp_tfsa_nest_eggWith RRSP season approaching, and the chaotic frenzy that ensues in January and February, I thought I would jump to the front of the queue and get the RRSP ball rolling for 2011. The premise of this article is that everyone should max out their TFSA’s first, and then consider whether they need to contribute to an RRSP.  Both investment vehicles grow tax free. The main advantage of the TFSA over the RRSP is you don’t have to pay taxes on the amounts you withdraw.

 

Conventional Wisdom

Conventional wisdom says to make the maximum contribution you are able to your RRSP. This adage is well entrenched in the financial industry in Canada, because RRSP’s were the only tax-sheltered investment available to ordinary Canadians. That was until 2009 when the federal government unveiled the TFSA (Tax Free Savings Account).  Although the TFSA is well established, many people have not seriously considered the benefits of the TFSA, and still continue to contribute to their RRSP’s

The wisdom is based on the fact that when you contribute to an RRSP that amount reduces your taxable income, and for most people that usually means a refund. It’s easy to look at the short term gain, RRSP = Refund.  So $1000 invested into an RRSP = approximately $250 refund in the lowest tax bracket.  And if you are in a higher tax bracket of course you get a higher refund (or at least lower your taxable income). Sounds like a winning game plan!

Forget the RRSP

But actually, if you look to the long term, you don’t win. Your RRSP contributions compound, growing tax-free, and after several years you will likely double or triple the value of what you originally invested.  And if you are younger, that compounded amount could be 4 to 5 times what you originally invested.

The tax man will eventually come back for his money he gave you as a refund – in the form of taxes. Money taken out of your RRSP is FULLY taxable, so the more you make the more taxes you pay. Even if you are in a lower tax bracket when you retire, you will still pay tax on all the money you withdraw. This taxable amount on the compounded investments over time, may possibly be more than the net benefit from the RRSP deductions you received in previous years. That’s something you need to work out with your accountant.

For example let’s say that $1000 invested earns a nominal average return of 5% per year in dividends and capital-gains for 20 years inside your RRSP, and let’s say for the next 19 years you diligently contribute another $1000 each year. So for the 20 years your total RRSP investment is now worth $35,719. Think about the taxes you pay on that!

Max Out the TFSA

On the other hand, money you withdraw from your TFSA when you retire is non-taxable 🙂  If the same amount in the example above was contributed to a TFSA, it would still have the same compounded growth. The difference being there would be no taxes to pay – that’s $35,719 that isn’t taxed. Nice!

Each year you are allowed to contribute a maximum of $5000 to your TFSA, and you can carry-forward any unused contribution room to future years. So basically if you can only contribute $3000 one year then the next year you can contribute $7000 ($5000 + the unused $2000 from the previous year).  If you haven’t contributed to a TFSA yet, you get the additional benefit of the unused contributions from the previous two years.  So your total contribution room in 2011 could be as high as $15,000 (2009 to 2011). Keep in mind with the TFSA however, that any money you withdraw reduces your contribution room for that year (i.e. withdraw $5000 from your TFSA and you will have to wait until next year to contribute).

Unlike an RRSP you do not get a tax deduction for your contribution, but your compounding returns still grow tax free! When you retire you can withdraw the money out of your TFSA without paying taxes. Congratulations you just made a tax-free investment.  So forget the RRSP, and be sure to make the maximum contribution to your TFSA first!

Who Should Use a RRSP?

If you are in a higher income tax-bracket, and an RRSP contribution will put you in a lower tax bracket, then the RRSP is worth considering. For high income earners the 5K per year TFSA contribution is nominal and will be used quite quickly. So contributing to an RRSP after the TFSA maximum would make sense. Or conversely a high income earner can simply optimize their RRSP contributions, so they pay no additional taxes, and then contribute to their TFSA. If you crunch the numbers, using free tax software such as Intuit’s Turbo Tax, you will be able to quickly determine the net benefit (if any) from an RRSP contribution.

High income earners generally can get the net-benefit from contributing to an RRSP and lowering their current taxes. That refund could then be used to reinvest in the following year’s TFSA, or even better help to pay down the mortgage.

But even if you are in a high income bracket, don’t forget to max out the TFSA first, because that money (as well as the compounding income) will be non taxable when you withdraw it at retirement. That 5K per year compounded over time, can amount to some big non-taxable benefits in the future!

Will You Still Feed Me When I’m 71?

Turning 71 and having a big RRSP nest egg could be a real hassle! That money either has to be converted into an Annuity or RRIF, or even worse withdrawn from an RRSP at your full taxable rate. With a TFSA however, there is no age limit on the holdings. You can keep it until your 92 if you want to!

Personally I would rather keep my own investments than deal with the uncertainty of trying to buy complex annuities from insurance companies, or deal with unforeseen interest rate environments.  I hate to sound simplistic, but annuities and commission based mutual funds are the same animal – they generate revenue for companies and brokers who sell them.  So stick with TFSA’s and avoid the turning 71 RRSP hassle!

Use your TFSA for an Investment Loan

Investments inside your RRSP cannot be used for collateral. But you can use the investments inside your TFSA as collateral for a loan – specifically for “good” debt such as an investment loan 🙂 The interest on this loan (unlike a RRSP loan) is tax-deductible. So use your TFSA as collateral to take out an investment loan.  As long as you don’t use that loan to contribute further to your TFSA or RRSP, then the interest is fully tax deductible. Once the loan is paid off (since you are writing off the interest) you can then contribute that amount back into your TFSA.

So if you borrow $5000 at a rate of 4% for investment, you can claim a $200 tax deduction.  Doesn’t sound like much, but it’s more than the taxes you will pay when you start withdrawing from your RRSP.  Think of it as a dividend to yourself!

Conclusion

Both investment vehicles the RRSP and TFSA grow tax free. The main advantage of the TFSA over the RRSP is you don’t have to pay taxes on the amounts you withdraw.

Please keep in mind I am not an accountant or professional advisor, and everyone likely has an individual circumstance that is very different from mine or someone else’s. You may find after reviewing your taxes and investment situation that an RRSP, TFSA, or a combination of both is most prudent. Regardless, I strongly urge everyone to sit down with their accountant and make their TFSA game plan for 2011!

31 Responses to “Max Out Your TFSA, and Forget the RRSP!”

  1. I completely agree (and in fact have a article drafted on the very topic).

    RRSPs offer a tax-deferral scheme for people. nothing more. I will hopefully have an income for a looong time (into “retirement”) so I will be paying taxes. Unlike most people I hope to be paying even more taxes than I do today (e.g. making more income). As such, RRSPs aren’t something Iput a lot of priority on (though I do have some).

    when compared to a TFSA, it is a no brainer for my tastes.

    Reply to this comment
  2. The Dividend Ninja

    Jan 11. 2011

    Jaymus, thanks 🙂 I’m looking forward to reading your TFSA article as well.

    Reply to this comment
  3. I totally agree! Same philosophy here. If you have any kind of expectation to maintain some sort of income when you near retirement, the deferred taxes aren’t as advantageous compared with a tax-free TFSA.

    TFSA first, then RRSP for tax optimization.

    Reply to this comment
  4. Stephen

    Jan 12. 2011

    If you have a limited amount to invest, there are still times that putting your money into an RRSP first makes the most sense. It really comes down to marginal tax rates now vs what you expect them to be when you retire. Try out some scenarios with this calculator

    Reply to this comment
  5. The Dividend Ninja

    Jan 12. 2011

    Hi Stephen, thanks for posting and providing the useful calculator link 🙂

    I think my point in the article is that it does not make sense to contribute to your RRSP first. Although you may indeed get a refund or reduce your taxable income, you will end up paying the taxes not only on that amount – but all the years of compounding on that original investment as well.

    Why pay more tax when you retire ? It really makes more sense to contribute to your TFSA first since there is no tax to pay when its withdrawn. If you have limited funds to invest all the more reason to use the TFSA first. Thanks for posting!

    Reply to this comment
  6. lovely leverage

    Jan 16. 2011

    Thank you for writing this. I know RRSP isn’t really something for me because I plan to receive more income when I retire. It looks like TFSA is more tax-efficient than the traditional tax-deferred strategy. Now I’m wondering whether I should put money in TFSA or start the smith maneuver.

    Reply to this comment
  7. The Dividend Ninja

    Jan 16. 2011

    @Lovely
    Yes for sure, max-out the TFSA first,then consider RRSP secondly if you have high income. I Can’t advise you on the Smith Maneuver, that’s not my expertise – but your accountant would be the person to ask 🙂

    Reply to this comment
  8. gammj

    Oct 08. 2011

    “Keep in mind with the TFSA however, that any money you withdraw reduces your contribution room for that year (i.e. withdraw $5000 from your TFSA and you will have to wait until next year to contribute).”

    Actually, no, your withdrawals have no bearing on your contribution room that year.

    Say you have $5000 already in a TFSA to start 2011. You get $5000 in new room for 2011. You could very well withdraw that $5000 and redeposit that same $5000 within 2011 because you have contribution room. On Dec 31, 2011 you would have $5000 in your TFSA and 0 contribution room. On Jan 1, 2012, because of the 2011 $5000 withdrawal you would now have $10000 in contribution room for 2012.

    Reply to this comment
    • The Dividend Ninja

      Jan 13. 2012

      gammj 8th Paragraph:

      “Each year you are allowed to contribute a maximum of $5000 to your TFSA, and you can carry-forward any unused contribution room to future years.”

      Cheers

      Reply to this comment
  9. Nick

    Apr 26. 2012

    Does a TFSA favor one type of investment over others?

    ie. Would dividend or growth equities be more appropriate for a TFSA if you had to choose one or the other?

    Reply to this comment
    • The Dividend Ninja

      Apr 26. 2012

      Nick, the only consideration is taxes. From a tax perspective it only matters with foreign content. The RRSP shelters everything from taxes, inlcuding what is deemed as foreign content.

      For example, you would want to hold U.S. Stocks in your RRSP and NOT your TFSA. The TFSA is not sheltered from U.S. Tax Treaties, and therefore the dividends would be taxable if a U.S. stock is held in the TFSA.

      Cheers
      The Dividend Ninja

      Reply to this comment
      • Nick

        Apr 28. 2012

        So if i were to begin building a base of index funds in my portfolio, it wouldn’t make any difference if i held US index/ETF’s in my TFSA or not.

        Reply to this comment
        • The Dividend Ninja

          Apr 28. 2012

          Hi Nick,

          No that is not correct. U.S. Index ETFs/Funds will distribute dividends and income as foreign content. You should hold U.S. Index ETFs/Funds in your RRSP and NOT your TFSA.

          That is something you may want to contact the ETF or fund company to verify… it all depends on how income is distributed by the fund.

          Cheers

          Reply to this comment
  10. Nick

    Apr 28. 2012

    So if i were to begin building a base of index funds in my portfolio, it wouldn’t make any difference if i held US index/ETF’s in my TFSA or not.

    Reply to this comment
    • The Dividend Ninja

      Apr 28. 2012

      Hi Nick,

      No that is not correct. U.S. Index ETFs/Funds will distribute dividends and income as foreign content. You should hold U.S. Index ETFs/Funds in your RRSP and NOT your TFSA.

      That is something you may want to contact the ETF or fund company to verify… it all depends on how income is distributed by the fund.

      Cheers

      Reply to this comment
  11. Dai

    Feb 03. 2013

    mmmmm, it is already time for RRSP. =(
    I am still looking for which bank I should switch to (currently I am with HSBC; Not interested)
    I don’t know any financial advisor/planner.

    My plans for this year are as follow.

    1, Find new bank to do RRSP/TFSA
    2, Open TFSA account to do Self Direct/Direct Invest. (good Web Broker)
    3, From this account, I would like to invest in Dividend.

    Please help someone….

    Reply to this comment
    • The Dividend Ninja

      Feb 04. 2013

      Something else I should mention, is that when you move your RRSP you will be hit with a transfer-out fee of around $150.

      Questrade will refund that if you are moving more than $25K into your RRSP. TDW will refund the transfer out fee if you ask, even if you are moving less. You need to phone before you transfer and ask for that. 🙂

      You can transfer your holdings over “in kind” which means you keep the investments you have, then you can sell them as you wish. Be careful as some mutual funds have back-end and deferred sales charges (no way around those).

      Cheers

      Reply to this comment
      • The Dividend Ninja

        Feb 17. 2013

        Hi Dai,

        Depends on what type of RRSP account you mean. It wouldn’t make much sense to have two seperate trading accounts. You could also incur extra fees by doing so.

        If you are already with HSBC then why do you need to open an account with TD Waterhouse? HSBC InvestDirect has all the features you need.What is it you want to achieve with TD you can’t with HSBC?

        What do you mean by “direct investment” ?

        Cheers

        Reply to this comment
  12. The Dividend Ninja

    Feb 04. 2013

    Hi Dai!

    Sorry for the late reply here. I recommend Questrade to start off with, becuase they have the cheapest fees at $4.95 per trade with no RRSP admin fees. You can also trade U.S. stocks without incurring foreign currency charges etc.

    I’m with TDW (TD Waterhouse) which is an excellent and responsive trading platform. You need a minimum of $25K to avoid the annual RRSP admin fee. No fees for TFSA, other than the trading fee. You need a minimum of $50K in assets with TDW for the $9.99 trade fee, else less than that you will pay $29 per trade. If you don’t have $50K, then TDW makes no sense.

    Others I know are pleased with RBC Direct Investing.

    Cheers 🙂

    Reply to this comment
  13. Dai

    Feb 17. 2013

    Hello Dividend Ninja.
    Thank you for your kind reply.

    Well, I should have asked you above questions after today. (but did it anyhow since below information was not available until I went to TD today and my above questions came across earlier)

    Well, today I went to TD to purchase RRSP however I didn’t know TD RRSP loan interest rate was higher than HSBC. (My wife and I have been using both TD and HSBC but HSBC for about 10yrs and TD is just 2yrs or so) So we didn’t do anything. Rescheduling for appointment later this momth.
    Should I still have two banks for my RRSP? ( I think we will be keeping both)

    Another question is also should have thought before asking you a question. Is it possible for a low income family with no extra cash available opening TFSA to do direct investment or this will be disadvantage? Is TFSA for only people with certain income earners and not for low income family?

    I kind of confused about TFSA
    Thank you for your advise.

    Reply to this comment

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