I recently read an in-depth analysis by David Chilton (AKA The Wealthy Barber) looking into a specific question: TFSA vs RRSP? I was inspired to do some in-depth analysis on my own.

One end result of doing all that research: I went ahead and created CI Direct Investing’s ultimate TFSA vs RRSP calculator. (Did I mention I’m a software developer?) I wanted to make it easier for people to see how these different kinds of investment options could give you better results. Another result: I now know more than I ever wanted to about how RRSPs and TFSAs work. Here goes.

TFSA vs RRSP. Which one is the right option for you?

The short answer to the TFSA or RRSP question is that it depends. That said, saving for your retirement income using your RRSP will beat saving in a TFSA for the most part and for most people.

“Okay,” you say. “But what’s with the emphasis on for retirement?”

First, let’s review how RRSPs work. While we initially get a tax break on RRSP deposits, we will eventually have to pay income tax on our RRSP withdrawals.

A few other things are considered income during our retirement. That includes money we receive from the government like Canadian Pension Plan (CPP) payments and Old-Age Security (OAS).

Add to that, any income we might receive on the side. Rental property. Money from selling curios on Etsy. Any of these things are considered income. So our taxable retirement income looks something like:

RRSP + CPP + OAS + Etsy + other = Taxable Retirement Income

Now on the other hand, when we withdraw amounts from ordinary (non-registered) savings and TFSA savings, these amounts are not considered income. That’s because we did not receive a deduction for the amount we contributed. In addition, in the case of ordinary savings, we also paid any taxes owed on growth (the money our money makes when it’s invested well). The TFSA has an advantage over the ordinary savings account as the growth is tax-free.

Why the RRSP is still better in the end (even if you have to pay tax on it in the end)

When you save money in your RRSP, your tax savings (or tax refund) is calculated at the marginal tax rate. This is the highest tax rate you pay, but when you withdraw you can consider your income tax in retirement as an average rate.

Also, in the period when you are building up your savings, you are likely to have a higher income (in today’s dollars) than when you retire. Typically, your retirement income needs are less than 80 percent of pre-retirement income.

Before retirement, you must set aside some income to save for retirement. After you retire, you don’t. Also, your mortgage may be paid off.

Keeping all that in mind, the RRSP will win. That’s as long as your marginal tax rate when you’re saving is higher than your average tax rate when you withdraw the funds. As I said earlier, the RRSP lets you defer paying tax until retirement.

Maximize RRSP savings to win

Chances are that maximizing your RRSP savings first is still the way to go. (If you’re already doing that, then by all means put any additional savings in your TFSA.)

Of course being just a ‘simple’ financial matter, there’s no way it could be that simple. We should also consider other things that impact our income in retirement.

For instance, there’s the old-age security (OAS) clawback which starts to kick-in you when your after-tax income exceeds ~$70k. That works out to about $90k of before-tax retirement income.

Furthermore, couples can “income split”. So that’s equivalent to $180k total household retirement income before the clawback kicks in. $180k of retirement income might be equivalent to over $225k in pre-retirement income. That’s true if we’re operating on the assumption of 80% of pre-retirement income in retirement.

That’s not too shabby. In fact, it’s in the top 5% of Canadians by income. But, let’s consider some other ways only saving using our RRSP might affect us.

Let’s say you’re at retirement age (or near it) and you’ve been diligent about saving for your whole life.

You also have this one dream: your very own 24′ sailboat and cruising the world in it.

This is a pretty big purchase. If you dip into your RRSP, it’s quite likely to put you waaaay over your normal income and tax rates for that year.

This is the perfect scenario for your TFSA. Saved for your boat using your TFSA? Then you can dip into your TFSA savings without increasing your income at all.

Compare the TFSA and RRSP using the marginal tax rate on the additional money you would have needed to withdraw from your RRSP to pay for the boat.

Now I feel we can answer the original question more accurately. Here it is again:

“When should I use my TFSA instead of my RRSP?”

1. When you are planning on saving for large purchases (either long or short term).

2. If your current income (and thus tax rate) is well below your expected future income.

3. You are planning to really “live it up” and significantly increase your lifestyle in your retirement.

Having some money in your TFSA can help you avoid taxes on large expenses during retirement. It can even help you avoid OAS clawback if you’re income level is high enough. Otherwise, use the RRSP. That is still the best primary account for basic retirement income savings.