There is a growing sentiment among Canadians that somehow RRSPs are a government scam because you’ll be forced to pay tax on any withdrawals in retirement.  That leads many to (sometimes) incorrectly declare that TFSAs are the better savings vehicle for retirement due to the tax-free treatment of withdrawals.

RRSP vs TFSA

Let’s start by clearing up one important fact in the RRSP vs. TFSA debate:  The accounts are mirror images of each other.  When you put money in an RRSP and invest the tax refund, you’re using pre-tax dollars.  The money grows inside a tax sheltered account and then you pay taxes on your withdrawals years later in retirement.

Related: What does pasta have to do with RRSPs?

The opposite is true of a TFSA – you contribute after-tax dollars but won’t have to pay taxes when you take money out.  If you’re in the same tax bracket when you withdraw from your RRSP as you were when you made the contributions, the RRSP and TFSA work out to be the same.

Here’s a simple chart that David Chilton used in The Wealthy Barber Returns to help drive this point home:

TFSA RRSP
Pre-tax income $1,000 $1,000
Tax $400 n/a
Net contribution $600 $1,000
Value in 20 years @ 6% growth $1,924 $3,207
Tax upon withdrawal (40%) n/a $1,283
Net withdrawal $1,924 $1,924

Two important caveats to keep in mind:

  1. You need to invest the tax refund in order for RRSPs to work out as designed.  Unfortunately, most Canadians spend their refund and so they don’t end up with as much money in their retirement account.
  2. TFSAs are flexible in that you can take out money at any time without penalty.  For Canadians using it as their primary vehicle for retirement savings that means resisting the temptation to raid the account when “something” comes up.

Obviously for high income earners who expect to retire in a lower tax bracket, it makes more sense to contribute to an RRSP.  For low income earners, or for young people with higher income potential later on in their careers, TFSA contributions make better sense.

Related: How much of your income should you save?

Another advantage in favour of RRSPs is the higher annual contribution limits – 18 percent of your income up to a maximum of $24,270 in 2014 – compared to just $5,500 for the TFSA.

One potential downside is that withdrawals from a large RRSP portfolio could trigger higher clawbacks from means-tested government benefits such as Old Age Security and the Guaranteed Income Supplement.  Withdrawals from a TFSA in retirement, on the other hand, won’t affect your eligibility for OAS and GIS.

Fans of the tax free savings account trumpet the “tax-free” withdrawal stage while conveniently ignoring that contributions were made with after-tax dollars.  And anti-RRSP zealots look to the big tax liability in retirement while ignoring all the deductions and years of tax-sheltered growth.

Final thoughts

So who wins the great RRSP vs. TFSA comparison?  It’s easy to say that you should max out both accounts every year, but realistically, unless you are blessed with a six-figure (plus) income, most of us will have to choose.

Related: How much do you need to save for retirement?

As Chilton concluded, it depends:

  1. If you go the RRSP route, don’t spend your refund.
  2. If you go the TFSA route, don’t spend your TFSA.
  3. Whatever route you go, save more!

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