Tax-shielding personal savings and investments is an important consideration to maximize long-term wealth. No resource exists that definitively and elegantly explains how individual Canadians should act to create long-term wealth using RRSPs and TFSAs. The following article tries to lay out a framework most people can understand and use.

Descriptions of these accounts exist everywhere but the main details are as follows. Both TFSAs and RRSPs are effectively tax-free saving accounts but TFSAs are taxed at the current rate while RRSPs are taxed at the rate at time of withdrawal. The other major difference is that TFSA contribution room is not decreased by withdrawals, whereas RRSP contribution room is decreased by withdrawals.

The value of one dollar invested in three possible accounts, after n periods is as follows:

RRSP

$(1+r)^n (1-T_n )$

TFSA

$(1+r)^n (1-T_1 )$

Margin Account

$(1+r(1-T_D) )^n (1-T_1 )$

Where:

$r$ is the return on investments $T_1$ is the current marginal tax rate $T_n$ is the marginal tax rate in period n, the time of withdrawal $T_D$ is the average tax rate on returns (which is a blend between dividend and capital gains tax rate)

We begin with the assumption that our goal is to maximize the value of our savings at some point in the future. It is then clear that TFSA is always better than a margin account. Therefore, there should never exist an underfunded TFSA together with a funded Margin Account. The only reason a TFSA should be underfunded is if investing in an RRSP is a better option. From the equations above, it is clear that an RRSP is better than a TFSA if the current marginal tax rate is higher than the expected marginal tax rate at time of withdrawal. Therefore, we need to analyze the shape of T.

For most people T increases over your life until it decreases to T_n. Presumably there will be a time over most people’s life when RRSP will be more beneficial than TFSA. It is therefore generally a rule that RRSP is preferable to a TFSA, which is preferable to a margin account. However, for people with increasing marginal tax rates (which is most of us) an RRSP contribution is probably suboptimal.

Consider deferring RRSP contributions by m years, at which time the marginal tax is T_2. The benefit of the deferral is:

$dT=T_2-T_1$

The cost is the lost tax shielding over the m years, which can be expressed as:

$[(1+r)^m-1](1-T_n )-[(1+r(1-T_D) )^m-1](1-T_1 )$

This is a hard equation to analyze, but testing a wide range of values show that in cases where marginal tax rate is increasing quickly, the benefit dT will be higher than the cost. Furthermore, while dT is a certain benefit (subject to correct assumptions of future income), the cost of lost tax shielding is market dependent. Therefore, in general it is beneficial for Canadians to defer RRSP contributions as their salaries are increasing quickly. For many people, this means waiting until taxable income increases past $84,902, $138,586, or $220,000, whichever one is “within sight” – say within 3-5 years. (N.B. taxable income is after tax deductions. An average person will have ~15,000 in deductions a year). Until then, maxing out TFSAs is a good policy.

Put in simpler terms, for a person who is taxed in the highest tax bracket, such a person should always max out RRSPs, TFSAs and Margin Accounts, in that order. The same argument applies for people in a lower bracket who know they will never reach a higher bracket. For people who will traverse brackets, the decision becomes less clear. It requires you to compare the additional tax-shielded return to the benefit of deducting RRSPs in a higher income bracket.