TFSA or RRSP: which account comes first?

For most people earning under $55,000, the TFSA comes first. Above $100,000, it's the RRSP. In between, it comes down to one thing: the tax you pay today, compared with the tax you'll pay in retirement. Here is how to find out for your own case.

What each account does, in one sentence

The TFSA: you put in money that's already been taxed, it grows tax-free, and it comes out tax-free. Whatever you withdraw is added back to your contribution room (the space you're allowed to fill) the following January 1st.

The RRSP: what you put in is deducted from your taxable income, so the government refunds part of it in the spring. The money grows tax-free. On withdrawal, all of it is taxed like salary, and the room you used never comes back. The RRSP holds a grudge like that.

In other words: the TFSA taxes you on the way in, the RRSP on the way out. Everything else follows from that.

The same $1,000 in each account

Take $1,000 of gross salary, a 40% tax rate today, 25 years invested at 5% a year, and a 30% rate in retirement.

The RRSP wins here because the tax on the way out (30%) is lower than the tax avoided on the way in (40%). Put the same rate at both ends and the two columns give exactly the same amount. Put a higher rate in retirement and the TFSA wins. That is the whole mechanism.

So the real question: your tax rate, now and later

The rate that matters is your marginal rate, meaning the tax you pay on the next dollar you earn, not the average across your whole salary. In Quebec it sits around 36% at $60,000 of income and passes 40% a little above $106,000.

If your rate will be lower in retirement than today, the RRSP wins: you skip tax at the high rate and pay it at the low one. If it will be the same or higher, the TFSA wins, and it leaves you free to withdraw whenever you like on top.

When the TFSA comes first

You're early in your career. At $45,000 of income, the RRSP deduction gives you back about 27 cents on the dollar; at $90,000, it will give back 37. RRSP room doesn't expire: keep it for the year your salary has climbed.

A good pension is coming. An employer plan, the Quebec Pension Plan (QPP) and Old Age Security (OAS) stack up in retirement. RRSP withdrawals on top can push you back to a tax rate as high as today's.

You might need the money before retirement. A TFSA withdrawal costs nothing. An RRSP withdrawal is taxed like salary, and the room doesn't come back.

When the RRSP comes first

You earn more than $100,000. At a marginal rate above 40%, every $1,000 contributed gets you at least $400 back in the spring. Few investments do that in year one.

Your retirement income will be clearly lower. The deduction at the high rate now, the tax at the low rate later: that is the scenario the RRSP was invented for.

You're buying a first home. The Home Buyers' Plan (HBP) lets you take up to $60,000 out of the RRSP tax-free for the down payment, to be repaid over fifteen years.

The FHSA, if you've never owned a home

The First Home Savings Account (FHSA) takes the best of the other two: you deduct the contribution from your income like an RRSP, and you take the money out tax-free like a TFSA, provided you buy a first home. On $8,000 contributed at 40% tax, that's $3,200 back on the way in and nothing to pay on the way out. No other account does both.

The limit is $8,000 a year and $40,000 over a lifetime. If you qualify and a purchase is in your plans, it comes before the TFSA-or-RRSP debate.

Three questions to settle it

And one thing the math doesn't show: the best account is the one money actually goes into, every month. A $200 automatic transfer into an “imperfect” account beats a perfect strategy applied twice a year, whenever you remember.

Going further

Before filling the TFSA, you need to know how much room is left, and it isn't the figure the Canada Revenue Agency shows, frozen at January 1st. Our TFSA contribution room calculator does the math with this year's withdrawals included, and TFSA limit: how much can you really contribute? explains the calendar rule that catches well-meaning people every year.