More Confusion Comparing TFSAs to RRSPs

When comparing TFSAs to RRSPs, it’s important to consider only the after-tax portion of your RRSP balance or you’ll be led astray. The concept of forgone consumption is helpful. Here I look at how to compare TFSAs and RRSPs when it comes time to draw from them in retirement.

In the third edition of his book Tax-Free Savings Accounts – How TFSAs Can Make You Rich, Gordon Pape includes a section on questions he has received from readers. Unfortunately, the answer he gives to one of the question leaves much to be desired. Here is a paraphrase of the question:

Q: I expect to run out of non-tax-sheltered investments in about 5 years. When this happens, should I start drawing from my RRSP or TFSA?

Here is Pape’s answer:

A: “Let’s suppose you have a $5000 investment in each plan earning 7 percent annually. Five years from now, that investment will be worth $7012.76. Now you are faced with a withdrawal decision. If you take the money from the RRSP, using a marginal tax rate of 30 percent, you will be assessed $2103.83 on the withdrawal. That will leave you with a net after-tax return of $4908.93. Note that is less that the value of the original $5000 investment, which means that all the income you earned over the five years and more went in taxes. By comparison, a TFSA withdrawal will be worth the full $7012.76 – you keep all the investment income.

“This example does not take into account the benefit of the tax refund you received for the RRSP contribution, but this is in the past. What you are concerned about now is realizing the highest after-tax return from invested money that is already tax-sheltered. Leaving the TFSA intact is the best way to do that.”

It’s hard to decide where to begin with this muddled answer. Pape is saying that if you are comparing equal-sized withdrawals from your RRSP and TFSA, drawing from the RRSP will leave you with more TFSA funds that are more valuable because they won’t be taxed in the future. This is hardly surprising when we compare drawing equal-size amounts from each plan, because drawing from the RRSP will leave you with less money to spend this year due to income taxes. In effect, it is a smaller withdrawal, so it makes sense that you’re left with more money afterward.

Presumably, the reader is making withdrawals because he or she wants a certain amount of money to live on. For someone in a 30% tax bracket, a $7000 withdrawal from a TFSA should be compared to a $10,000 withdrawal from an RRSP. Pape’s comparison is simply irrelevant.

The observation that 5 years of growth in an RRSP doesn’t cover the taxes that will be charged on withdrawals is unhelpful. The original $5000 should be thought of as $3500 for the reader and $1500 for CRA. Viewed this way, both parts grow together and the reader can think of his or her part as growing tax-free.

The real answer to the reader’s question is complex. In some cases it makes sense to draw from both the RRSP and TFSA to keep taxable income steady over the years and avoid getting into a higher tax bracket. For low-income earners, it can make sense to draw the entire RRSP in one or two years (and move it to the TFSA if there is room) so that they can collect the full GIS in future years. For high-income earners trying to avoid OAS clawback is a consideration.

Answering questions like this without adequate details from the questioner is challenging because the answer usually ends up beginning with “it depends ...”. In this case Pape’s answer seems unhelpful no matter the circumstances.