This is a good one to get out.
Out of my head, that is. As per my blog post two days ago.
I rattle this question around alot. I’ve asked many a person, and there doesn’t seem to be a huge consensus. It’s one of those, it depends.
Can you repeat the question?
Take a very simple example. It’s February 25th and you have $10,000 sitting in a savings account. Should you put that into a Tax-Free Savings Account (TFSA) or a Registered Retirement Savings Plan (RRSP)? If you don’t know the difference, check out an explanation by Adrian at Canadian in a T-Shirt. TFSA here, RRSP here. Full disclosure -> I’m a paid subscriber on his YouTube page.
Oh, and by-the-way, I’m not a financial advisor. So all the usual disclaimers on that, don’t sue me, do your own due diligence (DD in Millennial). I have no idea what I’m talking about!
RRSP. In our simplistic example if you put the $10,000 into an RRSP, you’ll turn around and get a $3,600 tax refund. That’s assuming you’re in (and stay in) a 36% marginal tax bracket. And you didn’t reduce at source. Don’t forget the RRSP contribution deadline is March 1st.
That’s why I’m writing the blog today, just a few days before that deadline. Which (ugh I know we aren’t supposed to start a sentence with that), btw, is really tomorrow, because the last two days of February fall on the weekend.
Fun fact -> February 2021 is a perfectly rectangular month. Full description on that here. And I’m a Christian, so yes, Sunday is the last day of the week.
Stay with me here.
Now, knowing that you are going to get a $3600 tax refund, you can take out a short-term loan for $3600 and invest $13600 into an RRSP. Now, you’ll get a $4,896 tax refund ($13,600 x 36%). You can pay off your short-term loan and still pocket just over $1200.
Or, planning ahead, you can take out a $4800 short-term loan, add that to your original $10000, put $14800 into an RRSP. Now your return is $14800 x 36% or $5328. Pay off the $4800 loan and pocket just over $500. Diminishing returns, yes, but I developed a formula that calculates the exact amount.
Where x = loan amount, y = initial principal, and z = marginal tax rate.
In our example, x is the unknown. Y is $10000, and Z is 36%. Plugging that in, the exact amount for our short-term loan is $5625. So you take out a $5625 loan, add it to the $10000 you have sitting there, and put $15625 into an RRSP. You get a tax refund now of $15625 x 36%, or $5625, and pay off the loan in its entirety.
Great, so if we go the RRSP amount, we can turn our $10000 into $15625. So why not go that way?
Because one day, you’ll retire and pull that out. And if your in the 36% tax bracket, you’ll be back to your original $10000 (plus any interest / growth you make in-between).
If you go the TFSA route, no fancy math and your $10000 grows tax-free since you’ve already paid tax on it. So you end up with the same amount of money.
Ok, so it’s a tie-breaker then? Flip a coin.
Not quite. Where the delta (difference) comes in is if you change tax brackets. I assume all the millennials have exited the chat by now.
Take the same $10000 and assume you’re in a 50% tax bracket now. Plugging that into our formula above, you can put $20000 into an RRSP. $10000, plus a $10000 loan. Your refund will be $10000 ($20000 x 50%), pay off the loan. Now you have $20000 working hard for you.
Fast forward to retirement, pull that $20000 (plus growth) out, but now you’ve dropped to a marginal tax rate of 36%. Well you only get dinged with a $7200 tax bill (only?), so you walk away with $12800. That’s more than the $10000 if you had left it in a TFSA.
That is how I understand an RRSP works. It’s a deferred tax vehicle, so you kick your tax obligation down the road until, hopefully (?), you’re in a smaller tax bracket.
So now we can conclude, based on all of this and my non-tax-expert rambling, if you think you’re in a higher tax bracket than you’ll be in retirement, go RRSP. Otherwise, TFSA.
That’s generally what most financial advisors have told me…but.
There’s this thing called Canadian Child Benefit (CCB), Goods and Services Tax (GST) and / or Harmonized Services Tax (HST) refund(s), and Canada Education Savings Grant (CESG). You see, if you lower your taxable income by contributing to an RRSP, the amount you get for those starts to ratchet up as well. But I’m already past a page, so that will have to wait for tomorrow.